Good Article on HF industry;
Instrument in the News: Hedge Funds
financeweek.co.uk
Alan Shipman - 24-Sep-2007
By moving quickly in and out of undervalued assets, insulating against the downside and taking subscriptions only from the deepest pockets, they're intended to produce high returns for limited risk. But their inclination to bet with borrowed money tested global bank stability nine years ago, and a bad third quarter has raised fears that another unravelling is under way.
In principle they invest for high return in ways that guard against loss, inflict any downside on wealthy shareholders, and support a market for financial instruments that make it easier for companies to expand. But after several years when they made an important contribution to mainstream bank, insurance and investment fund profits, a reversal in hedge funds’ fortunes is now weighing on the balance sheets of some of them. The US federal reserve says there’s no problem – but limited disclosure requirements mean it’s unclear whether that assurance is prompted by firm knowledge, or a need to avert wider panic.
What they are
Investment funds that use active management to pursue high returns, often mobilising large sums to make use of short-lived profit opportunities when sharp movement in an asset price is expected. The term ‘hedge’ is applied because, traditionally, funds went short on equities (or other instruments) they believed would fall in value at the same time as going long on those they expected to rise, providing some insulation against a sudden general downturn in prices of the asset.
Hedge funds assemble large sums of capital by selling shares to large institutional investors and high-net-worth individuals. But they multiply the returns on this equity by borrowing large additional sums to invest alongside it. Hedging is intended to defray the obverse risk, of multiplying losses if a judgement on price movement goes awry.
The funds tend to be heavily purchasers of derivatives, instruments that enable profit on an underlying instrument if it moves in the anticipated direction and limit the loss if it goes the other way. However, some no longer hedge in the traditional sense, instead taking a ‘one-way bet’ on price movements their managers feel certain of. This certainty is often increased by the use of sophisticated forecasting models. The potential for loss-making on derivatives, when they are bought with high leverage and the losses go unmonitored, were highlighted when Nick Leeson’s Singaporean trades brought down Barings Bank in 1997.
What they do
Because their versatility across underlying instruments detaches them from the pattern of volatility of those instruments, hedge funds offer a unique asset class into which big institutions or rich individuals can diversify. Their ability to switch also offers a potentially higher return than other funds, because of managers’ freedom to go wherever they see profit – and a safer return, because they are not bound by rules that sometimes depress other funds’ returns. (For example, a tracking fund may have to follow its chosen index downwards, and a fund that is mandated to invest in equities may not have the scope to move back into cash when equities are about to fall). Even when they are taking risky one-way bets, the type of shareholder hedge funds target is willing to take that risk, having placed the rest of their portfolio in lower-yielding but safer destinations.
Why they’re in the news
A year ago, the main complaint about hedge funds was that they made a few rich individuals even richer, by exercising an economic leverage that could make whole nations poorer. A fund run by George Soros famously made $10bn betting on the pound’s devaluation in 1992. But at least the Hungarian-born philanthropist made some of this available to educational and charitable organisations in emerging markets through his Open Society foundation. More recently, relentless selling by funds has been implicated in various stock-market and currency crashes in less advantaged economies, forcing them into painful austerity measures and enterprise restructurings that their people can ill afford.
This year, the concern is that the funds themselves are losing money, and could inflict damage on the entire world if big banks and investment funds – which had turned to them as a source of high yield in a world of low interest rates – are found to have lent more to them than they can afford to write off. A forewarning of the damage that can be done, when a large fund has borrowed heavily on a one-way bet that turns sour, was provided in 1998 by Long Term Capital Management. LTCM had to be rescued with $3.5bn, subscribed by around 15 large banks under US federal reserve system supervision, to avoid systemic risk to the whole global banking system. The fund, its image enhanced by principal shareholders who included Nobel prize-winning economists, and by annualised returns exceeding 40% in 1995 and 1996, had assembled a $200bn portfolio with capital of just $4.8bn, was at risk of losing it all after a gamble on interest rates was derailed by the Russian and Asian debt crises.
A tide turning?
Since the LTCM near-miss the number and size of funds has grown, and mainstream financial institutions have increased their use of them, even though they fall outside the reporting and other regulatory requirements imposed on other types of investment fund. The funds’ strong performance this decade has amplified the profits of many banks, and their buying-power has ensured a market for new financial instruments (including collateralised debt obligations) that assisted fundraising by fast-growing banks and businesses. But their resilience to a global rise in interest rates and slowdown in growth has not been tested, and early signs are not encouraging. In the past month some prominent funds have run into financial difficulty after heavy withdrawals provoked by a drop in value.
US investment bank Bear Stearns has reported a 62% drop in Q3 net profits after it had to rescue three hedge funds that had had previously made strong profits on US sub-prime debt, but were left holding it when the market turned sour this year. Two of Bear’s funds have already declared bankruptcy, and while other investment banks have had to set aside similar sums for nonperforming hedges, the impact on its Stearnings is more severe because fixed-income was providing more then 40% of its total profits a year ago.
Swings and roundabouts
Although their return on investment is down, in most cases it’s far from out, and still ahead of many other types of investment. Funds as a whole lost 1.3% of their value in August, leaving their eight-month rise at 6.2%, according to consultancy Hedge Fund Research.
According to Bloomberg, investment bank Morgan Stanley has chosen this moment to buy up to 21% of Traxis, the hedge fund set up by its former chief strategist Barton Biggs – which was still up around 8% at the start of this month, despite a 2.5% drop in August. US federal reserve chairman Ben Bernanke assured a US Congressional committee last week that “we have not had any significant counterparty losses arising from the hedge funds.” In London, Man Group - whose funds are collectively the world's biggest with $68bn under management - has denied any upturn in redemptioons and says that fee income for the half-year to end-September will be up 15% from a year ago.
But where there isn’t a big bank to support them, undiluted good performance can suddenly turn to ice with nothing to restore liquidity. Hedge fund manager Absolute Capital was forced to suspend redemptions for a year last week, after the abrupt departure of founder Florian Homm, who had failed to persuade other managers to forgo their bonuses and inject more of their known funds while performance was down. Absolute’s assets more than doubled in the year to June as funds under Homm’s management made annualised returns of 30%+. But their reversal this year brought an upturn in withdrawals which became a rush for the exit after Homm’s departure, with depositors attempting to retrieve up to $100m. Unlike those besieging the Northern Rock, the mainly wealthy clients didn’t queue in the street, even though Absolute is headquartered in sunny Majorca.
Unlike those bank depositors, who could walk away with their money after the UK government stepped in to underwrite the bank, Absolute’s shareholders have had to sit tight as the company admits it can’t immediately pay, because it can’t sell many of its US shareholdings at a realistic price. Rather than dump these at a loss, Absolute hopes to persuade its trapped clients that they will do better to wait a year while it issues them with new shares in a special fund set up to house the problem holdings – a run-off vehicle comparable to those used by insurers when the payouts overwhelm the premium income. The company insists that $1.1bn of funds invested in bonds and real estate are unaffected by the crunch; but $2.1bn in the hedge funds are, and the whole company’s future is placed in doubt by the departure of Homm, who is its largest shareholder.
Where they’ll go next
The losses some funds have made in the third quarter could still be redeemed by the fourth, if managers can use their legendary agility to switch into the assets that are still making money. But problems arise when they have made a heavy one-way bet, and haven’t made enough return to cover their debt costs, or face substantial extra borrowing to buy back assets they mistakenly shorted, at higher cost.
Because they are not forced to report their exposures as rigorously as other types of fund, regulators can only gauge the damage done by hedgers by watching the impact on mainstream institutions that have lent to them or bought their shares. Several smaller failed hedge funds may not sum to the systemic impact of one LTCM; but for that reason, financial regulators may fail to launch the lifeboats as quickly as they did in 1998.
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