Relative Value Strategy Data Profile: The Kings of Leverage

If you want to find the nexus of systemic risk within the global shadow banking system, you must look at Relative Value hedge funds. These quantitative funds utilize massive, highly leveraged balance sheets to capture microscopic pricing inefficiencies in the deepest, most liquid markets on Earth.

Unlike Long/Short Equity funds that bet on the directional movement of a stock, Relative Value funds are inherently market-neutral. They do not care if the broader market goes up or down. Instead, they identify two highly correlated assets whose prices have temporarily diverged from their historical mathematical relationship, and they bet heavily that the prices will eventually converge back to normal.

According to the SEC Form PF data compiled by the OFR, Relative Value funds command [DATA: Total Net Asset Value, Relative Value, latest quarter] in NAV. However, their true systemic footprint is revealed by their staggering Gross Asset Value (GAV).

Fixed Income Arbitrage: The Core Strategy

The absolute titan of the Relative Value category is Fixed Income Arbitrage. Sovereign bond markets (specifically U.S. Treasuries) are the fundamental bedrock of global finance. Because they are traded by massive, slow-moving institutional players (central banks, foreign governments, commercial banks), temporary pricing inefficiencies occur constantly across the yield curve.

The Treasury Basis Trade

The most famous—and systemically dangerous—Relative Value trade in modern finance is the Treasury Basis Trade.

There are two ways to gain exposure to U.S. government debt: you can buy the physical "cash" Treasury bond in the open market, or you can buy a Treasury Futures contract traded on the Chicago Mercantile Exchange (CME). In theory, the cash bond and the futures contract should trade at the exact same price, because they represent the exact same asset.

However, because asset managers prefer the extreme liquidity of the futures market, the futures contract often trades at a very slight premium to the physical cash bond. The Relative Value fund detects this microscopic premium and acts as an arbitrageur. They will sell (short) the expensive futures contract, and buy (go long) the cheaper physical cash bond. By doing this, they lock in the tiny difference (the "basis spread") as a risk-free profit, ensuring that when the contract expires, the prices will converge.

The Necessity of Extreme Leverage

The catch to the Treasury Basis Trade is that the pricing discrepancy is incredibly tiny—often measured in just a few "basis points" (hundredths of a percent). If a Relative Value fund executes the trade with un-levered cash, they might make an annualized return of 0.25%. No institutional investor will pay hedge fund fees for a 0.25% return.

Financing via the Repo Market

To transform that 0.25% return into a 15% return, the Relative Value fund must apply massive leverage, routinely operating at 50x to 100x their equity. They achieve this via the Repurchase Agreement (Repo) market.

The fund takes the physical Treasury bonds they just bought and hands them to a Prime Broker as collateral. Because U.S. Treasuries are considered risk-free collateral, the Prime Broker applies a microscopic haircut (e.g., 1%). The Prime Broker lends the fund physical cash against the bonds. The fund then takes that newly borrowed cash, buys more Treasury bonds, hands those back to the Prime Broker, borrows more cash, and repeats the loop dozens of times.

Systemic Vulnerability: The March 2020 Shock

When you apply 100x leverage to a trade, you must maintain absolute mathematical perfection. If the "risk-free" trade goes slightly wrong, you are wiped out instantly.

This exact scenario nearly destroyed the U.S. Treasury market in March 2020 during the onset of the COVID-19 pandemic. As panic gripped global markets, a massive "dash for cash" occurred. Normally, in a crisis, physical Treasuries rise in price as investors seek a safe haven. However, in March 2020, the opposite happened. The spread between the physical cash bond and the futures contract suddenly blew out (widened) dramatically instead of converging.

Relative Value funds that were levered 100x on the Basis Trade were suddenly facing billions of dollars in losses. Their Prime Brokers issued immediate margin calls. To meet the margin calls, the hedge funds were forced to aggressively dump their physical U.S. Treasuries into the open market. This forced selling by highly levered arbitrageurs overwhelmed the market, causing the price of U.S. sovereign debt to crash. The Federal Reserve was forced to intervene with trillions of dollars in emergency quantitative easing to save the market from the very funds that were supposed to be providing it with liquidity. This event is why the OFR monitors Relative Value leverage so aggressively today.

Frequently Asked Questions