Hedge fund losses and meltdowns
Hedge funds haven't had a proper stress test since summer 1998. Then as now the problems had been brewing for several months but the "efficient" market failed to immediately factor them in. Other similarities to that time; dumb funds using massive leverage to short liquidity, short the yen, short optionality, lend to dubious borrowers (Russia then, sub-prime mortgages now) and trade on useless pricing models that bore no relation to actual market behaviour. Funny how these things often break in the summer "doldrums". There were also predictions of the widespread death of the hedge fund space when in fact it strengthened the industry. This time will be similar.
Many risk assets fell recently; stock markets, high yield bonds, high yield loans and high yield currencies. Many real estate and private equity holdings also fell but their price won't be known until someone bothers to value them properly. Asset allocation doesn't help much when correlations across risky securities tend to +1. The mythical "LBO put" also evaporated; there is no floor on the market. Credit and equity are two sides of the same coin yet some still seem to treat them as if these asset classes were unconnected. A portfolio of assets is not sufficiently diversified to be sure of making money in turbulent times. Strategies that do NOT need easy market conditions are a mandatory portfolio component.
Small losses are acceptable, meltdowns are not. Every strategy, every fund AND every asset has negative months sometimes. Skill, risk management, short selling and portfolio nimbleness are what determine if the loss can be kept acceptably low. It is why strategy and manager diversification is even more important than asset allocation. SMALL losses are inevitable but a wide spread of bets, shorts and longs, hedging and knowing your risks AHEAD of time are what prevents BIG losses. Illiquidity and other non-linear exposures combined with leverage is asking for trouble unless you know what you are doing. Why did so many believe in the free lunch of high yields at low yield risk?
Hedge fund pioneer Alfred Winslow Jones considered the purpose of his equity hedge fund was to guard against a stock market drop. He got it right over 50 years ago yet the semantic abuse continues. Hopefully recent market events will bring renewed attention to Jones' definition. A credit hedge fund's purpose is to guard against a credit market drop. Period. If a proposed "alternative" strategy is not set up to do just that what is the point in investing in it? I've been doing strategy evaluation and due diligence for a long time yet still encounter many "hedge funds" with scant risk management, reluctance to be net short, dependent on easy conditions and optimistic assumptions. If you want optimists go with the long only crowd. It is easier and the chance of 100% loss is almost zero.
Credit spreads are basically options premiums; if you buy a risky bond or loan you are in essence writing a put on that debt. Such a strategy is short volatility and hazardous if the premium does not compensate for the intrinsic default probability. As with many options selling strategies, taking in premium works fine UNTIL you get blown away by a fat-tailed move. It is with good reason that the ONLY thing I try to do with explicit or implicit optionality is to own it, NEVER short it. Bear markets are better than bull markets in that you make money much quicker. That's also why I like buying "value" volatility. Unlimited upside with a known downside and guaranteed to produce lots of alpha in kurtotic markets.
Credit modeling and risk measurement is NOT rocket science. It is more complex than that. The latest, but not the last, leverage and illiquidity induced blow up is Sowood Capital. Interesting how "market-independent" Sowood turned out to be dependent on credit beta just like Amaranth was on energy beta. Being so concentrated in one area and charging hedge fund fees for simply gearing up investments in credit spreads is absurd. What they were doing was more complicated but simplifying this game: suppose you raise $100 from investors and borrow another $900 from leverage providers (really cheap in yen!). Then place the whole $1,000 into higher yielding assets and maybe short something low yield. If your "model" says the portfolio is worth the same a year later, you've "made" over 10% after fees but with no skill, no alpha and no justification in calling your product a hedge fund. Sowood wasn't a hedge fund any more than C-Bass; it just took in inadequate insurance premiums on mortgage-backed securities and hoped for the best.
Citadel, which actually is a hedge fund, bought out some of these positions because it is "hedged" and like anyone sensible keeps capital available for when good opportunities occur. Other real hedge funds like Tudor and Caxton apparently had a rough month, giving back a minute fraction of their cumulative capital gains over the last two decades. It is much easier to pilot a speed boat than an oil tanker. Both were among the best hedge funds in the 1980s, quite good in the 1990s but have increasingly become oil tankers in recent years. It is very difficult to reconfigure large portfolios and take aversive action when a regime change hits the market which is why staying in liquid areas and closing strategies to new money is so important. Still Paul Tudor Jones and Bruce Kovner are probably good enough to figure out ways to make the money back assuming the funds are now correctly marked. Ken Griffin had a rough 2005 during the CB arb meltdown but seems fine now.
Many index and long only funds are underwater for the decade, again. "Alternative" ASSETS don't help if they drop just like traditional assets but are able disguise this price volatility and market dependence through delayed mark to market. We are also getting an overdue shake-out of "hedge funds" that were not managing strategies that diversified a portfolio. Alternative STRATEGIES are the way to be more confident of protecting capital whatever the conditions. Hedge fund naysayers will cite June/July 2007 to show they were right all along yet the truth is the sub-prime meltdown PROVES the case for risk-managed funds and diversifying by STRATEGY not only by ASSET.
Jeremy Grantham, the permabear "G" of GMO, is too BULLISH on the hedge fund industry. He thinks only 5000 will disappear in the next 5 years. There will certainly be more credit spread bozos shutting down soon. But after that I would hope we lose 80% to attrition like in other entrepreneurial business sectors. Some will go because they were very good but more will go because they weren't. Managers with genuine ability will thrive and alpha is a redistribution game anyway. We've seen plenty of alpha transport in recent weeks as the skilled made money out of the unskilled. That's real portable alpha; other funds' negative alpha becomes your positive alpha. If anything a crisis just increases the money-making opportunities. Creative destruction and business Darwinism is healthy for any industry. The dotcom implosion didn't hurt internet growth either. I am a permabull as far as technological innovation and people figuring out ways to make money is concerned.
It is so long since we had a proper shakeout to show who has been swimming naked in an outgoing tide. Ideally we have entered an extended period of flat to negative asset returns which is the ideal environment to detect genuine alpha generating ability. Whatever the market does and whether Grantham proves correct, 5 years from now the hedge fund industry will be far larger than today and there will be many more "start-ups" to replace all those "close-downs". Hedge funds are no more a fad than email or blogs.
Markets are a leading indicator not a lagging. At least the economy is strong according to economists who always seem to be able to succinctly explain the past. It is true the economy WAS strong but that does not mean it WILL be strong. Seems hard to believe that risk aversion, reduced loan availability, higher borrowing rates for weaker credits, scepticism of ratings and less private equity deal flow will NOT have an effect on the liquidity driven world economy. The market always tends to "know" a lot more about the future than economists. Equity traders also know a lot more than equity analysts. Credit markets know a lot more than credit models.
As previously blogged I've been long implied volatility and short various credit indices for months but it is probably time to book those profits. Still short of FIG and BX but no need to cover those yet. The implications of tighter credit and stricter loan covenants for private equity are not yet discounted. Seven "analysts" issued "buy" ratings on BX today so clearly there is a lot more downside! If those sales-side cheerleaders were required to put at least 5% of their net worth into BX at the $31 IPO price I might start paying attention to their "opinions". But doing the opposite to what equity analysts say is usually reliable.
I wonder if those "research" reports noted the moral hazard of going public when your rivals remain mostly private. There was no way to short big private equity before 2007 but there is now. Quite kind to provide global investors with the ONLY short sell plays on private equity. Even if those firms themselves are good, their public currency allows anyone to implement negative views on the industry. Merger arb used to be "buy the acquiree, short the acquirer". Reverse merger arb worked like a dream recently as spreads widened but normal merger arb might look favorable now the strategics have the upper hand. With KKR wavering on its IPO, Blackstone and Fortress are out in the cold as proxies for possible private equity problems EVEN if their own portfolios and dealflows are fine.
The risk-adjusted performance of real hedge funds has been vastly superior to long only public AND private equity and they offer essential strategy diversification. While I realize many people far smarter than me are skeptical of hedge funds, my analysis of hedge fund performance leaves NO room for doubt that proper hedge funds offer important value to a portfolio. Even if some lose money and a rare few blow up, the spread of returns and strategies is the key value proposition. Asset allocation is less important than strategy allocation and hedge funds are strategies NOT assets. As we saw last week long only funds are not sufficient.
It has been a long time since tough trading conditions and while many products had been making money easily this year, the numbers for June/July show which funds have been generating alpha and hedging out that beta. As we experienced 9 years ago, financial contagion is not yet contained. Risk and failure are absolutely necessary in a functioning financial system and during such crises there is ALWAYS opportunity. There is plenty more money still to be made out of this situation if you are nimble enough to capitalize on it. The current credit market dislocation just PROVES the case for quality hedge funds in REDUCING portfolio risk. 
Many risk assets fell recently; stock markets, high yield bonds, high yield loans and high yield currencies. Many real estate and private equity holdings also fell but their price won't be known until someone bothers to value them properly. Asset allocation doesn't help much when correlations across risky securities tend to +1. The mythical "LBO put" also evaporated; there is no floor on the market. Credit and equity are two sides of the same coin yet some still seem to treat them as if these asset classes were unconnected. A portfolio of assets is not sufficiently diversified to be sure of making money in turbulent times. Strategies that do NOT need easy market conditions are a mandatory portfolio component.
Small losses are acceptable, meltdowns are not. Every strategy, every fund AND every asset has negative months sometimes. Skill, risk management, short selling and portfolio nimbleness are what determine if the loss can be kept acceptably low. It is why strategy and manager diversification is even more important than asset allocation. SMALL losses are inevitable but a wide spread of bets, shorts and longs, hedging and knowing your risks AHEAD of time are what prevents BIG losses. Illiquidity and other non-linear exposures combined with leverage is asking for trouble unless you know what you are doing. Why did so many believe in the free lunch of high yields at low yield risk?
Hedge fund pioneer Alfred Winslow Jones considered the purpose of his equity hedge fund was to guard against a stock market drop. He got it right over 50 years ago yet the semantic abuse continues. Hopefully recent market events will bring renewed attention to Jones' definition. A credit hedge fund's purpose is to guard against a credit market drop. Period. If a proposed "alternative" strategy is not set up to do just that what is the point in investing in it? I've been doing strategy evaluation and due diligence for a long time yet still encounter many "hedge funds" with scant risk management, reluctance to be net short, dependent on easy conditions and optimistic assumptions. If you want optimists go with the long only crowd. It is easier and the chance of 100% loss is almost zero.
Credit spreads are basically options premiums; if you buy a risky bond or loan you are in essence writing a put on that debt. Such a strategy is short volatility and hazardous if the premium does not compensate for the intrinsic default probability. As with many options selling strategies, taking in premium works fine UNTIL you get blown away by a fat-tailed move. It is with good reason that the ONLY thing I try to do with explicit or implicit optionality is to own it, NEVER short it. Bear markets are better than bull markets in that you make money much quicker. That's also why I like buying "value" volatility. Unlimited upside with a known downside and guaranteed to produce lots of alpha in kurtotic markets.
Credit modeling and risk measurement is NOT rocket science. It is more complex than that. The latest, but not the last, leverage and illiquidity induced blow up is Sowood Capital. Interesting how "market-independent" Sowood turned out to be dependent on credit beta just like Amaranth was on energy beta. Being so concentrated in one area and charging hedge fund fees for simply gearing up investments in credit spreads is absurd. What they were doing was more complicated but simplifying this game: suppose you raise $100 from investors and borrow another $900 from leverage providers (really cheap in yen!). Then place the whole $1,000 into higher yielding assets and maybe short something low yield. If your "model" says the portfolio is worth the same a year later, you've "made" over 10% after fees but with no skill, no alpha and no justification in calling your product a hedge fund. Sowood wasn't a hedge fund any more than C-Bass; it just took in inadequate insurance premiums on mortgage-backed securities and hoped for the best.
Citadel, which actually is a hedge fund, bought out some of these positions because it is "hedged" and like anyone sensible keeps capital available for when good opportunities occur. Other real hedge funds like Tudor and Caxton apparently had a rough month, giving back a minute fraction of their cumulative capital gains over the last two decades. It is much easier to pilot a speed boat than an oil tanker. Both were among the best hedge funds in the 1980s, quite good in the 1990s but have increasingly become oil tankers in recent years. It is very difficult to reconfigure large portfolios and take aversive action when a regime change hits the market which is why staying in liquid areas and closing strategies to new money is so important. Still Paul Tudor Jones and Bruce Kovner are probably good enough to figure out ways to make the money back assuming the funds are now correctly marked. Ken Griffin had a rough 2005 during the CB arb meltdown but seems fine now.
Many index and long only funds are underwater for the decade, again. "Alternative" ASSETS don't help if they drop just like traditional assets but are able disguise this price volatility and market dependence through delayed mark to market. We are also getting an overdue shake-out of "hedge funds" that were not managing strategies that diversified a portfolio. Alternative STRATEGIES are the way to be more confident of protecting capital whatever the conditions. Hedge fund naysayers will cite June/July 2007 to show they were right all along yet the truth is the sub-prime meltdown PROVES the case for risk-managed funds and diversifying by STRATEGY not only by ASSET.
Jeremy Grantham, the permabear "G" of GMO, is too BULLISH on the hedge fund industry. He thinks only 5000 will disappear in the next 5 years. There will certainly be more credit spread bozos shutting down soon. But after that I would hope we lose 80% to attrition like in other entrepreneurial business sectors. Some will go because they were very good but more will go because they weren't. Managers with genuine ability will thrive and alpha is a redistribution game anyway. We've seen plenty of alpha transport in recent weeks as the skilled made money out of the unskilled. That's real portable alpha; other funds' negative alpha becomes your positive alpha. If anything a crisis just increases the money-making opportunities. Creative destruction and business Darwinism is healthy for any industry. The dotcom implosion didn't hurt internet growth either. I am a permabull as far as technological innovation and people figuring out ways to make money is concerned.
It is so long since we had a proper shakeout to show who has been swimming naked in an outgoing tide. Ideally we have entered an extended period of flat to negative asset returns which is the ideal environment to detect genuine alpha generating ability. Whatever the market does and whether Grantham proves correct, 5 years from now the hedge fund industry will be far larger than today and there will be many more "start-ups" to replace all those "close-downs". Hedge funds are no more a fad than email or blogs.
Markets are a leading indicator not a lagging. At least the economy is strong according to economists who always seem to be able to succinctly explain the past. It is true the economy WAS strong but that does not mean it WILL be strong. Seems hard to believe that risk aversion, reduced loan availability, higher borrowing rates for weaker credits, scepticism of ratings and less private equity deal flow will NOT have an effect on the liquidity driven world economy. The market always tends to "know" a lot more about the future than economists. Equity traders also know a lot more than equity analysts. Credit markets know a lot more than credit models.
As previously blogged I've been long implied volatility and short various credit indices for months but it is probably time to book those profits. Still short of FIG and BX but no need to cover those yet. The implications of tighter credit and stricter loan covenants for private equity are not yet discounted. Seven "analysts" issued "buy" ratings on BX today so clearly there is a lot more downside! If those sales-side cheerleaders were required to put at least 5% of their net worth into BX at the $31 IPO price I might start paying attention to their "opinions". But doing the opposite to what equity analysts say is usually reliable.
I wonder if those "research" reports noted the moral hazard of going public when your rivals remain mostly private. There was no way to short big private equity before 2007 but there is now. Quite kind to provide global investors with the ONLY short sell plays on private equity. Even if those firms themselves are good, their public currency allows anyone to implement negative views on the industry. Merger arb used to be "buy the acquiree, short the acquirer". Reverse merger arb worked like a dream recently as spreads widened but normal merger arb might look favorable now the strategics have the upper hand. With KKR wavering on its IPO, Blackstone and Fortress are out in the cold as proxies for possible private equity problems EVEN if their own portfolios and dealflows are fine.
The risk-adjusted performance of real hedge funds has been vastly superior to long only public AND private equity and they offer essential strategy diversification. While I realize many people far smarter than me are skeptical of hedge funds, my analysis of hedge fund performance leaves NO room for doubt that proper hedge funds offer important value to a portfolio. Even if some lose money and a rare few blow up, the spread of returns and strategies is the key value proposition. Asset allocation is less important than strategy allocation and hedge funds are strategies NOT assets. As we saw last week long only funds are not sufficient.
It has been a long time since tough trading conditions and while many products had been making money easily this year, the numbers for June/July show which funds have been generating alpha and hedging out that beta. As we experienced 9 years ago, financial contagion is not yet contained. Risk and failure are absolutely necessary in a functioning financial system and during such crises there is ALWAYS opportunity. There is plenty more money still to be made out of this situation if you are nimble enough to capitalize on it. The current credit market dislocation just PROVES the case for quality hedge funds in REDUCING portfolio risk.
by Veryan Allen, Copywrite 2007.
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