March 25, 2008
Hedge funds ought to celebrate while they can
So far so good - or at least, not too bad - seems a fair assessment of how the financial crisis has so far treated hedge funds. Although some have collapsed, including two managed by Bear Stearns, and others have hit trouble, they have generally done better than big financial institutions.
One hedge fund manager I talked to this month estimated that hedge funds with equity of about $15bn had so far been mortally wounded in an industry that now manages $2,000bn of assets. He compared this to financial institutions such as Citigroup and Merrill Lynch (and now Bear Stearns) that had suffered more.
But I do not think we have yet seen the full impact of the financial crisis on hedge funds. As banks that have kept hedge funds in business by lending them money and providing other services pull back - and it becomes much harder to leverage equity with debt - some funds will face a colder climate.
Martin Wolf, my colleague, wrote a sceptical column last week about the economics of hedge funds and how managers had perverse incentives to take risks to make big returns over a year or two before going bust. That column has produced an indignant response on the letters page of the Financial Times today.
Christopher Fawcett, chairman of the Alternative Investment Management Association in London, agrees with the hedge fund manager with whom I talked that hedge funds have demonstrated superior risk management and investment skills to “many of the largest financial institutions”.
I think there is probably something to the idea that the top rank of hedge fund managers are better prepared to handle risks than big financial institutions and have the first pick of talented fund managers.
There are, however, signs that hedge funds are finding it harder to obtain the terms on offer in recent years, when prime brokers owned by financial institutions (including Bear Stearns) competed to grant them financing.
James Mackintosh reported in the FT yesterday that:
Troubled hedge funds are increasingly going cap in hand to their owners and investors in an effort to avoid banks seizing assets or forcing them to sell into a falling market.
Carrington Capital Management, which is offering investors an 18 per cent payout on preferred shares in an effort to raise up to $200m to replace bank debt, is the latest. But others, including funds from Peloton Partners, Goldman Sachs, Citigroup and Carlyle have all looked to parents or investors for bail-outs – with mixed success.
So I think it is too soon to declare victory for hedge funds. We are likely to see more fall-out from the credit crisis and the unwinding of what Paul Krugman calls “the shadow banking system”.
Is the assets under management figure you list before or after leverage?
Posted by: Matt | March 25th, 2008 at 7:06 am | Report this commentI wonder if Christopher Fawcett can substantiate his claim that hedge funds have demonstrated superior risk management, given that the funds are largely unregulated, opaque and secretive.
I take it that Carlyle is an anomaly and that the gearing they have indulged is not representative of widespread incompetence and recklessness throughout the hedge fund industry. I also take it that the hedge fund managers that have been bragging of the scale of leverage worked into their funds are a small, vocal minority of yobs who actually don’t understand the meaning of “hedge”.
Time will tell. At least the banks are beginning to understand that gearing equity thirty to forty times is a tad risky, but I think you are likely to be right in suggesting that we’re going to hear and see more pain!
Posted by: Jim | March 25th, 2008 at 10:45 am | Report this comment“funds are largely unregulated, opaque and secretive.”
to the general public, but not to its administrators, prime brokers (who tend to know all) and of course the investors who are informed regularly.
Also CCC, the Carlyle fund wasn’t a hegde fund, it was a quoted entity.
Also, the point made here is illustrated by funds owned or managed by large financial institutions hence defeating the argument. If the funds that suffer the most are those managed by the likes of Bear or Carlyle (a private equity firm) then it doesn’t say anything about the “real” hedge funds.
Also, like all industries that have experienced a massive growth, some funds got started and never were worthy of it hence are more likely to fail. But that again doesn’t say anything about the industry intrinsically, it’s what generally happen in any industry: more competition, less survivors.
And of course some funds will blow up or more likely wind down for lack of performance or (more often even) because they can’t reach AUM that make the operation profitable. As for conflicts of interests, what about banks prop-desk? Also, many funds (especially now) manage their own capital alongside investors. And finally, this isn’t about for or against hedge fund, for or against commodities etc.. it is about diversification! Most investors are far overweight in equities or in property (that house that is falling rapidly in value). Of course it makes sense to add some exposure to say a macro strategy, a CTA, maybe an arb etc.. (that’s the other important point: hedge funds mean all and nothing really - strategies are really what is important to look at.)
Posted by: fxtrader | March 25th, 2008 at 2:06 pm | Report this comment““funds are largely unregulated, opaque and secretive.”
to the general public, but not to its administrators, prime brokers (who tend to know all) and of course the investors who are informed regularly.”
I don’t think this is necessarily true.
Not wanting to rely on any single prime broker (PB), many HFs have multiple PBs, making it hard for any PB to get the full picture.
In addition, not all OTC trades are given up to the PB (many complicated trades can’t be handled by the PB system), so these are executed vs. trading counteparties.
Many HFs also try to game the different requirements (PB requirement vs. trading counterparty requirement for collateral), in order to increase leverage.
Also, many HFs still disclose very little to its investors. Many just provide a single number (unaudited monthly return). Even if disclosure of info such as leverage, risk measurements, are adequate, these come out 10~30 days after month end, and so for many funds with lots of turnover in trades, so such info are almost meaningless. The annual audited reports may be detailed but comes out 2-3 months after year end.
Many administrators are overwhelmed, with poor systems, lack of training of staff, staff turnover, etc. Many HFs are not happy and are beginning to set up own administrators operating at arms length (perhaps with other HFs).
Even if the administrators get the full picture, I don’t think that matters to be honest. They’re not in a role to do anything about it, even if they had the capability.
Posted by: bob | March 25th, 2008 at 8:31 pm | Report this commentBob - good points. I agree with the issues you raised - yet, this isn’t particular to hedge funds.
Banks are obviously very active in OTC trades for example. Counterparty risk (while that’s a risk that few would have even considered 1yrs ago) is not unique to HF. Currently there’s momentum to move quite a bit of OTC onto regulated exchanges - no doubt increased risk aversion (on exchange, the counterparty is the exchange hence much less counterparty risk) and the greed of exchanges (CME group, Nyse/Euronext etc…) are driving this, but is this a structural shift or one that is merely cyclical?
Exchanges can only really focus on the most traded standardised products - and on those, it’ll probably be hard to keep trading OTC. Yet, so much of OTC is for specific, virtually unique trades so I doubt that’ll go away.
Again CCC (Carlyle) was listed.
As for PBs - well given that market is essentially sawn up for GS and MS (maybe JP will benefit from Bear deal), it’s not like HF have hundreds of PBs to choose from. And in practise the PBs will want to know the trades that don’t go through them.
And clearly, like with any rules, gaming/bending is always a risk. But how is that a specific HF risk?
A problem of relevance/timeliness with accounts? Again is that so unique to HFs? Isn’t this the very same issue with so every other company accounts? How many firms (non-financials) had to restate accounts / were sued for false/misleading accounting etc…
If one is saying that it’s important to scrutinize accounts, but also take them with a pinch of salt - I’d agree but I’d say it’s equally true whether it’s HF or any other set of accounts.
Now, problems with administrators exist - some administrators have had a tough time with lawsuits etc… Tension is bound to exist between HF and admins. Yet, one can’t say banks are doing a good job there, say SG and CS recent mishaps. Moreover, the accounts of Enron (and countless others) were signed off by the accountants and auditors. Refco, the broker, was in PE ownership, then IPOed by no less than 4 of Wall St’s best and brightest, not to mention the lawyers and accountants and yet a $400m fraud was not uncovered!
So Bob, I agree with the issues you highlighted but they’re not really specific to hedge funds. Equally, if one was attacking HF for example for blocking redemptions, then how is that different from say some real estate funds?
Posted by: fxtrader | March 26th, 2008 at 11:21 am | Report this commentThey are valid criticisms of course. (try the performance indices, the relative short life of the industry, the fact HF seems long equities, shareholder activism etc.. )
And of course, some in HF will bend the rules, charge outrageous fees, do silly trades etc…
That’s the case in business in general not just some HF.
fxtrader, good points.
Just to be clear, I’m not anti-HF. Just wanted to highlight some issues.
It’s difficult to talk about HF as an industry as characteristics, practices, the people, etc, of HFs differ greatly, but in general, I do believe their existence has been positive and they often get blamed for things not unique to them.
I’d say that the gradual reduction of “reputable” bank/broker-dealer counterparties through mergers etc has been a concern for risk professionals for quite a while. No great solution has been put forward though - some temporary solution was to tighten the CSA threshold, take off trades, etc.
I’m still a bit sceptical on the ability of PBs though. In the end, they are looking at the cushion built in to their terms to protect them.
I guess it’s up to the investors to decide whether 2/20% is worth it or not, check on risk management systems, disclosure levels, etc.
Posted by: bob | March 26th, 2008 at 8:31 pm | Report this commentThere’s no way anyone can sustain alpha returns.
The bigger you rise, the harder you fall.
This crisis was inevitable.
Yes, hedge funds will further suffer just as PE firms have.
But I think this credit crucnh is a good measure to seperate the good from the bad companies.
I am quite certain there will be a flurry of regulations once the dust settles.
Hedge funds like securitization is all very opaque. Things must be somewhat clear. Let’s face it if Credit Suisse cannot calculate its books, what chance does the average Joe have?
Posted by: Bhavin P. Kapadia | March 31st, 2008 at 12:50 am | Report this comment