Veryan Allen: Hedge fund crisis

7.24.2007

Hedge fund crisis

Hedge funds should love a crisis. It is when market inefficiencies and mispricings are at their greatest. The current structured credit problems are nicely demonstrating the differences between good managers and non-skilled funds that simply exploited an unstable and temporary risk premium. Skill based, long volatility strategies are really the only fund management products likely to profit from market turbulence except perhaps government bonds.

Most public domain arbitrage strategies with a short volatility profile run into problems over time especially if leverage and illiquidity are involved. Two years ago we had a CB arb "crisis" and currently we have a fixed-income arb "crisis" hurting the beta bandits and helping the alpha dogs. Both offered money making opportunities to those managers with the capability to exploit them. Alpha is zero sum so the ONLY way to produce alpha is for other market participants to lose money.

It is important when picking investment styles to differentiate between skill-based and risk premium based strategies. I don't think funds dependent on simply exploiting a risk premium can be considered hedge funds. Many forms of credit and fixed-income arbitrage rely on such phenomena. The yen carry or positive yield curve trades are examples. Similarly with equities only a fraction of micro-cap or emerging market "hedge funds" actually are hedge funds; many are just playing the risk premium often exhibited by such assets during strong bull markets.

The core strengths of the alternative investment industry are strategy diversification and performance dispersion. With traditional funds if their benchmark is down, it is likely they are also down. It is unfortunate some investor capital has been lost through unjustified confidence in sub-prime linked credit products. This just confirms the need to identify proper hedge funds and even then put in only a small proportion of capital. For many investors that means quality funds of funds will probably be the best entry point. The 80/20 rule tends to apply here; only 20% of hedge funds are good and only 20% of funds of hedge funds are good at picking those funds.

In optimizing portfolio construction for alternative investments, I have usually found the maximum an investor should have in any one fund is 5% and therefore 95% in unrelated, independent strategies. Even if one accepts naive credit carry as a legitimate "hedge fund" strategy (which I do not), the most any investor would have lost from these CDO-linked meltdowns would be 5% of their TOTAL alternatives portfolio. If they have spread their bets properly they will also have money with other funds that benefit from the dislocation. That is the reason EVERY investor should allocate to short-biased equity and credit funds; even if the returns have been poor (so far!) the critical importance of negatively correlated strategies to managing portfolio risk should not be underestimated.

Most good hedge funds use quite low leverage, if at all. It is true weaker alternative investment products employing high leverage may blow up which is why due diligence is so important in determining that expertise and risk management are present. Rare event risk and massive losses are hardly confined to incompetent hedge funds. United Airlines, Worldcom and Enron and thousands of other equities lost all their shareholders' capital but that does not mean people should avoid ALL stocks just because some dropped 100%. Hundreds of dotcoms imploded a few years back losing several hundred billion for investors but Ebay, Amazon and Google and many others have performed well. Good hedge funds aren't going away any more than good technology stocks. The bear market of 1973/74 blew away dozens of long biased beta dependent "hedge funds" while George Soros, Michael Steinhardt and others thrived.

As a value investor I value strategies able to achieve consistent absolute returns at low risk. I think investors should be compensated for risk. When I look at a hedge fund I am looking for a margin of safety - performance should be much higher than the risk. Volatility is NOT risk but it is a useful first cut. Over time the S&P 500 has generated about 8% a year at 15% standard deviation so its returns have been derisory compensation for its risk. Most other equity indices and long only funds offer an even worse value proposition. Investors need products that give DOUBLE digit returns at SINGLE digit risk. 10%-14% a year at 5%-7% sigma is AVAILABLE if you do your homework. 30% a year at 15% vol is also fine but definitely NOT the other way around. Which is common sense - low risk, high return or high risk, low return?

Ideally performance is generated from securities that are liquid and frequently valued. Funds straying into illiquidity need to provide compensation for taking on that much less manageable exposure. Often it is weaker funds that wander into the minefield of things that hardly ever trade. The analysis get more complicated when a strategy is taking rare event or assumption risk. Several of the recent blow ups gave the appearance of low volatility due to investing in rarely traded, mark to model instruments. If there is a lot of leverage involved you have to look at whether the returns compensate for that gearing.

It is not in the nature of proper hedge funds to blow up, it is the nature of those who have useless trading models, baseless assumptions, don't understand complex strategies or proprietary risk management to blow up. It all comes down to experience in actually trading the strategies and due diligence in identifying whether the targeted returns are sufficiently high from the risks being taken. For illiquid, mark to model funds, 1% a month was woefully below the required return for any margin of safety in obviously hazardous long biased credit strategies.

Lending to the US government at 5% is not a bad bet but a higher yield from slicing and dicing sub-prime mortgages into allegedly bankruptcy-remote vehicles was not. Some neophyte investors place far too much reliance on "independent" agency opinions. Debt ratings are paid for by the issuer and most equity "ratings" are purchased by promises of investment banking business. Proper fund managers pay NO attention to what analysts think of a security and ignore ratings agencies. Just because Moody's or Standard and Poor's say something is AAA does not mean it is. There was nothing "High Grade" about those sub-prime mortgage concoctions.

It was absurd to assign a measure originally designed for rock solid government and corporate debt to the untested (till now!) financial alchemy of CDOs, CLOs and CPDOs. It is applying a fundamental metric to model-based credit structuring using wildly optimistic assumptions of default and recovery rates and correlations of different borrowers. Collateral is "sound" only if someone else will buy it at prices you "assume". If product structurers want to rate shop for a sellable classification that is their freedom but investors should ignore them. The only things "investment grade" are those assets whose rewards outweigh the risks. How shortsighted to gain a few hundred basis points for a while but end up losing 100%.

Just because MSCI, FTSE or Nikkei place a stock in their index does not mean it is any good. If a broker's cheerleader team (aka stock analysts and strategists) say something is a "strong buy" does not mean you should not short it. Morningstar putting 5 Stars on a mutual fund provides no information on whether to buy it. The "ratings" put out by various firms on hedge funds and hedge fund index construction are even worse. I have seen industry awards given to "top" hedge funds that weren't even hedge funds and some that imploded soon afterwards.

I am typing this watching the British Open golf championship. The Carnoustie effect is defined as "that degree of mental and psychic shock experienced on collision with reality by those whose expectations are founded on false assumptions." Sounds familiar with the current sub-prime CDO crisis demonstrating a classic reality check. A question to ask investment managers claiming to run a hedge fund, "What exposure does your strategy have to the Car-Nasty effect?". If the strategy assumes sunny market weather and normal distribution fairways, walk away.

There are other parallels between finance and golf. While everyone recognizes there are skilled golfers able to negotiate "random" Scottish weather some deluded souls continue to doubt the existence of skilled funds able to negotiate "efficiently" priced markets. Such skill MUST be in limited supply. Of all the people who have ever swung a sand wedge, few would be justified in calling themselves "golfers". Much fewer deserve to be considered "world class golfers". Similarly only a small proportion of "hedge funds" actually are hedge funds and fewer still are world class hedge funds.

The media sports pages focus on the stars while the financial pages focus on the losers. When academics study hedge funds they try to study EVERY product that says it is a hedge fund and bothers to report to a database. Hedge fund indices and "investable" hedge fund index funds are an even dumber idea than stock or bond index funds. The indexers would have you believe every large open hedge fund is worth owning! Even most legitimate hedge funds are avoids, let alone all the impostors and risk premium players. Can you imagine the average score at the Open if every "golfer" played?

It all comes down to doing your homework backed up by due diligence and advice from those who truly understand alternative investment strategies. And diversifying sufficiently so that possible negative performance of any one fund or strategy does not have a debilitating effect on your portfolio. Twenty hedge funds managing different strategies that have little correlation to each other is probably the MINIMUM number necessary.