How subjective is AIFMD’s objective leverage ratio?

Has that goal been achieved? In this article we focus on one particular risk measure, the leverage ratio and consider how different interpretations could, or could not, lead to different leverage ratios for the same portfolio.

The leverage ratio is one of the key risk measures that the e Alternative Investment Fund Managers Directive (AIFMD) prescribes. This ratio provides insight in the composition of the funds’ assets and liabilities and therefore the ability of a fund to meet its financial obligations. A leverage ratio higher than zero may help a fund amplify returns in good times. By the same token, however, leveraged funds with disappointing returns can turn against the fund’s investors and may even lead to a fund’s default. It is thus important for investors to understand the extent to which the fund manager uses leverage to obtain investment objectives. However, no simple measures exist to measure leverage and the way it must be defined may depend on the funds composition. For instance, if an equity fund has borrowed 10% of its net asset value through an in interbank loan, one may say it has a leverage ratio of 10%. But what if it buys out-of-the-money call options for 10% notional of the total portfolio? It is clear, that options are also a form of leverage, but did this strategy also add 10% leverage? Or more, or less than 10%? What if it didn’t only buy call options, but also bought put options? Clearly, such strategy lowers the leverage. Can we net this with leverage created with the call options? And if there is nothing to net, could the leverage ratio be negative? These are not straightforward questions to these answers. Therefore, the AIFMD has set standards and articulated methods to measure the leverage ratio. The leverage ratio must be monitored internally is and also reported to the regulator. The regulator can exercise its power to set thresholds, such that its leverage does not become excessively large. In this article we address some issues regarding the interpretation of the AIFMD leverage method, and show how small differences in interpretation can lead to significant differences in the reported leverage ratio.