Sunday, March 30, 2008 0 comments ++[ CLICK TO COMMENT ]++

Another Bubble Pops: Hedge Funds

Almost every economic boom results in the rise of certain financial assets to celebrity status. In the late 90's, the dot-com bubble resulted in IPOs (initial public offerings) being all the rage. Recently, the real estate bubble led to a boom in certain derivatives, with disastrous results in ABS of RMBS (asset back securities of residential mortgage backed securities) and CDO of ABS of RMBS (CDO stands for collateralized debt obligation). But this write-up isn't about any of them. Instead, this is about the rise and fall of hedge funds.

Hedge funds--the given label being as foggy and mysterious as the funds themselves--have been around for more than 50 years. Two of the most famous investors of all time, Benjamin Graham and Warren Buffett, ran hedge funds many decades ago. They are nothing new and are not going to completely dissapear. The question, instead, is whether they have grown too big--often on promises of unsustainably high returns--and will shrink. I fall into the camp that thinks there are too many hedge funds and the industry will be much smaller going forward. Do note that I am just some working class guy (which means I can't invest in them) and don't work in their industry. So it's purely an outsider's view. Some might argue this to be an ill-informed view (after all, how can one hold such a strong opinion without actually investing in several hedge funds) but I'm sticking with my view.

No better article to talk about hedge funds' troubles than one from The Telegraph out of Britain (thanks to Naked Capitalism for original mention). The British would surely know given that London is one of the major hubs for hedge funds (the other is the state of Connecticut in USA.) As usual, I will quote items that I find interesting but if you have an interest in hedge funds, read the full articles.

(source: Hedge fund legends hit by financial crisis, 30/03/2008. The Telegraph (UK) )

Hedge funds morphed from being American, secretive and peripheral to becoming one of the most important influences on global markets. Assets grew from about $200m in 1998 to an estimated $1.5 trillion at the end of last year.

You or I may not come into contact with hedge funds, or even know what they really are, but make no mistake about it: they are massive and heavily influence the markets. According to the quote above, they control $1.5 trillion, compared to around $50 trillion of total stock market capitalization for the world, around $50 trillion for the bond market, and $45 trillion (notional) for CDS (credit default swaps, where hedge funds are a major player). Hedge funds also invest in commodities, gold, art, collectibles, and so forth, but those are smaller markets. As a comparison, mutual funds in the US represent around $12 trillion of assets. Given that only the wealthy or institutions are allowed to invest in hedge funds, this $1 trillion figure is quite impressive.

With their dominance came increasingly displays of hubris and extravagance. Two years ago Albourne Partners, a hedge fund adviser, hired Knebworth and staged Hedgestock - the "alternative conference for the alternative investment industry" - one of the most extravagant and bizarre business meetings ever organised.

There were talks and meetings like any normal business conference, except the grounds were decked out as if it were a 1960s music festival, with the additions of a polo field, laser clay pigeon shooting range, hot-air balloon station and remote-controlled duck racing, while 4,000 delegates were dressed as hippies and danced to a live performance by rock giants The Who.

Meanwhile, London's annual Ark dinner, the industry charity night, became the biggest fund-raising night in the world...

Even when the markets turned last year, the hedge funds' high jinks continued. Stephen Partridge-Hicks, the former Citibank debt guru and head of Gordian Knot, one of the big credit hedge funds and so hit first, tackled the crisis by splurging thousands of pounds on a show-stopping party. In October, as his fund tanked, he chartered a plane to fly 150 mates to Morocco where he had hired Marrakech's upmarket Amanjena hotel for a James Bond-themed party. On top of the usual champagne and haute cuisine, Patridge-Hicks staged a James Bond scene - complete with actors, stunts, a real submarine and a fly-by from two Mig jets - starring himself as 007.

Arrogance & hubris are the downfall of any human. Ask George W. Bush and his neoconservatives who marched into Iraq expecting roses for simply being there. Hubris may also have brought down Elliot Spitzer. I personally am not concerned with Spiter's personal actions regarding prostitution but his arrogance against others certainly was sure to bite back. It seems a lot of the hedge fund managers have succumbed to hubris as well. Their almost inevitable fall is probably written on some wall somewhere.

I remarked in a posting a while ago about the fall of Victor Nierderhoffer, who fell victim to Mr. Market last year after losing to the same demon during the Asian Flu financial crisis back in 1997. Well, the latest ones to be struggling are John Meriwether and Eric Rosenfeld of LTCM fame.

Many hedge funds collapse under the sword that led them to glory--the glory of outperforming a superinvestor like Warren Buffett for many years. That shiny sword is none other than debt! Unlike the favoured sword of King Aruthur, the sword of leverage does not work in your favour all the time. Leverage has a nasty habit of swinging back towards you when you least expect it.

Without leverage I suspect many hedge funds would be shown for what they are. Namely, empty machinations that can barely outperform someone off the street. Mind you, they can crush losers like me who invest in questionable entities like Ambac but I'm referring to much saner investors, like the readers of this blog ;). The typical modus operandi of hedge funds is to take a small gain and boost that through leverage. Of course, the possibility of a small loss multiplied by leverage is never considered. I suppose it is beyond some people's arrogance to consider the possibility of themselves actually ending up with a small loss which turns into a big one.

The leverage situation seems to be quite acute for quantitative funds and credit market funds. All of that makes sense to me. For instance, the potential return in many debt instruments is very small so hedge funds tend to use leverage to multiply the return. A 3% return turns into 15% with 5x leverage but a 3% loss results in a -15% return.

When Walter Schloss says to avoid debt at all times, maybe he is not really advising value investors; maybe he is providing some valuable lessons to overleveraged hedge funds ;)

Another problem, even for unleveraged/lowly leveraged funds, is that their investors are very short-term oriented. The hedge funds do have legal tools to block withdrawls but they seem insufficient at times. For instance, some of these funds are in a crisis even though they are only down 8% to 15%. This is in the neighbourhood of the broad markets (or mutual funds) so it isn't the end of hte world. There is also nothing to say the funds won't bounce back in an year.

In some sense I can see why hedge funds face problems even if they are down a moderate amount. Investors pay high fees and I imagine they expect top-notch performance. So why wait around or put in more money when things look shaky? In contrast, investors pay a tiny fee for mutual funds and switching around mutual funds (or withdrawing funds) doesn't really have much impact.

One prime broker said: "Hedge funds have had it easy. Every man in a pink Cadilac has been able to raise money, start a fund and do really well. Frankly, those who have taken the biggest risks have come off best because markets have been so extraordinarily kind."

The biggest risktakers being rewarded the most reminds me of some executives of financial firms. Some of the financial firms that are struggling--some on the verge of bankruptcy--also had many highly compensated executives. In a perverse outcome, the as the risk was ratched up, executives end up with larger and larger pay packages. Some misguided compensation consultants also somehow managed to convince board of directors to raise the floor for the executives so that if something terrible were to happen, it would be laid at the feet of shareholders. If you don't believe anything I'm saying, go and ask any shareholder of Merril Lynch, Citigroup, MBIA, Ambac, CIBC, Washington Mutual, Credit Suisse, or [insert your favourite name here]. Sorry about the rant but I see big similarities between what I perceive as misguided executive compensation and hedge fund management compensation.

One said: "Hedge funds got carried away. Benevolent markets meant that anyone could be a superstar which couldn't be true. The current crisis will quickly show the pretenders and leave behind those that are genuine hedge funds - that can make money whatever the weather."

Unfortunately for hedge funds, I believe there are only a very tiny number who fit the description above. The vast majority of mutual funds underperform passive indexes and it won't be any different for hedge funds.

So, what will the result be from the shrinkage in the hedge fund industry? Well, in the short term, I expect some volatility related to de-leveraging and liquidation sales. No one knows for sure but it seems like hedge funds are heavily invested in thinly traded securities, emerging market stocks, and commodities. I'm in the bear camp when it comes to commodities so it wouldn't surprise me to see them collapse if more hedge funds start unloading their assets. Hedge funds are also big players in the credit default swap market. It would not surprise me to see violent disruptions in some of those markets. I am quite suspicious of the CDS market given that it is unregulated and there is sizeable counterparty risk. Fortunately the CDS market is net-neutral (like all derivatives are) so a loss by one party will result in an equal gain by another.

In the long run, hedge funds will fall out of favour with the wealthy elites and institutional funds--these are basically their only investors. If we are entering a bear market (the stars are starting to align in favour of a bear) then those that can't post positive returns will likely dissapear. One of the advantages of hedge funds is supposedly their low correlation to the broad markets. If they can't prove their lack of correlation to the broad markets, they have no reason for existing...

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