Monday, 8 December 2008
Market Mood
In past bear markets, hedge funds were able to use different strategies to keep making money. But that’s not the case in the current financial turmoil. On top of the substantial losses they have incurred, the size of hedge funds’ assets have fallen sharply with a flood of redemptions. Many hedge funds have responded by trying to restrict the redemptions, much to the chagrin of investors.
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Market Mood
Paul Pong
7 December 2008
In past bear markets, hedge funds were able to use different strategies to keep making money. But that’s not the case in the current financial turmoil. On top of the substantial losses they have incurred, the size of hedge funds’ assets have fallen sharply with a flood of redemptions. Many hedge funds have responded by trying to restrict the redemptions, much to the chagrin of investors.
Sandra Manzke, the chief executive at US-based Maxam Capital Management, sent a letter to investors last month lambasting the “bad apples” in the hedge fund industry - whose development she has followed closely. As early as 1985, when there were only 68 hedge funds in the market, she invested in them. Now they number more than 10,000.
In her letter, Ms. Manzke said some hedge fund managers prohibited or delayed redemption requests by not releasing the net asset value or winding up, causing losses to investors. Some hedge funds have abolished the “high watermark mechanism” - which prevents the taking of fees when funds lose money and fail to make up the loss - to increase management fees.
She hoped to organise a coalition, to discipline the industry as a whole in order to protect the interests of investors and restore their confidence.
I share Ms. Manzke’s view. But there are a lot of good long-term performers, and some fund managers can indeed be justified in charging high performance fees. As long as investors can get decent returns, they are willing to invest even if the fund managers are charging a high performance fee. So supervision of the hedge fund industry because of the “bad apples” is unfair to the “good” funds. “The good” will finally survive and “the bad” be kicked out. Supervision is good, but over-supervision will endanger the entire hedge fund industry.
According to data from Credit Suisse/Tremont, only short-selling and managed futures strategies have made profits, unlike in past bear markets.
But why are hedge funds losing money? Let’s look into convertible arbitrage as an example. The strategy in convertible arbitrage is mainly to buy convertible bonds and short-sell the same issuers’ common stock to make a profit. This used to be low-risk, but that changed with the widespread prohibition of naked short-selling. On top of that, investment banks and prime brokers request deposits. So hedge funds following this strategy have had to rewind their positions, further lowering the price of convertible bonds.
Convertible bonds can be split into two parts - bond and call options. The former is influenced by corporate credit and interest rate changes. And the latter is subject to stock price and its volatility. Some funds following the convertible arbitrage strategy trade against the volatility difference between the call option incorporated in the convertible bond - and the implied volatility of the option. This strategy is called volatility arbitrage.
The implied volatility of convertible bonds is calculated with the price of credit default swaps and the benchmark interest rate. If that volatility is lower than the implied volatility of the option, the fund manager will go “long” on the convertible bond (expecting its price to rise) and go “short” on the option (expecting a fall in price) - or enter a volatility swap contract. Profits are made when the implied volatilities gap narrows.
These apparently flawless and well-designed hedge fund strategies have been hit hard in this financial crisis. Stock exchanges’ prohibition on short-selling forced convertible arbitrage hedge funds to sell convertible bonds for settling their previous positions. As the liquidity of the convertible bond market is relatively low, the bonds became oversold.
On the other hand, the London interbank offered rate (Libor) rose sharply in the past six months. Prime brokers increased lending charges and maintenance margin levels for hedge funds significantly. Hedge funds with arbitrage strategies tend to rely on leverage to increase profits. When prime brokers tightened their lending policy, the funds were forced to sell securities, or even prime assets. The situation only worsened with the flood of redemption requests.
The large amount of redemptions has led to the overselling of some assets, like convertible bonds. So investors may invest in convertible bond funds, which now look attractive.
Traditionally, bond prices rise when interest rates fall. US Federal Reserve chairman Ben Bernanke has hinted at further cuts in US interest rates. This has pushed down the 10-year Treasury yield, which fell from 3.7 per cent to 2.7 per cent in just two weeks. The duration of 10-year Treasury bonds is about 7.5 years. In other words, when yield decreases 1 per cent, its price will increase by 7.5 per cent - a large increment by Treasury market standards.
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