Hedge funds took a beating last year, in their books but also in the press where they were lambasted for their opaque business practices.
JC de Swaan, Princeton University 13 March 2009
What a difference a year makes. Between 1989 and the end of 2007, hedge funds returned an annual average of 14 percent, with only one down year in 2002 when global markets plummeted 21 percent. That year and only that year hedge funds logged a negative average return of 1.5 percent.
By that measure, 2008 was cataclysmic. Last year, hedge funds returned negative 18 percent on average, according to Hedge Fund Research, with poor performance pervasive across almost all strategies. Only global macro strategies and funds that had a short bias ended up in the green. The other lost big, of which the biggest was Convertible Arbitrage at negative 35 percent.
In assessing the industry’s performance, Scott Bessent, a Senior Managing Director at Protégé Partners and a lecturer in economic history at Yale University, highlights two salient questions: What were investors’ expectations? And what did their hedge fund allocation replace in their portfolio?
Hedge funds are structured, and are pitched to investors, as absolute return investment vehicles – their ability to go both long and short and their relatively flexible investment mandates are supposed to enable them to make money in up-markets and down-markets, a characteristic often embedded in their marketing pitch. By the same token, their compensation is structured on an absolute-return basis – in addition to their management fees set as a percentage of assets under management (AUM), they receive incentive fees as a percentage of profits, starting at the first dollar of profit rather than at profits above any kind of benchmark.
The question regarding what hedge fund allocation typically replaced is harder to address. If hedge funds solely replaced equities in a portfolio, there would be more of a case for hedge funds’ outperformance in 2008. But that is debatable. Ever since Yale University’s David Swensen led the way by aggressively, and successfully, investing in alternative assets such as hedge funds, endowments and many other institutional investors have followed, resulting in a shift in portfolio compositions away from both equities and fixed income, toward these alternative assets.
Deep Restructuring
The Lehman Brothers bankruptcy and the ensuing collapse of the developed world’s financial system led to a massive acceleration in redemption demands from hedge fund investors, who, like all other participants in capital markets, were starved for liquidity. Quiet negotiations and testing of the waters by hedge funds in early Fall 2008 gave way to, often leaked, letters to investors in October and November and a period of time when announcements of major fund restructuring – typically imposing some sort of restriction on fund withdrawals – surfaced on a quasi-daily basis.
Recent estimates suggest that managers representing as much as half of the industry’s assets under management have imposed restrictions. These have taken the form of either “gates,” which temporarily disallow investors any fund withdrawals, or side-pockets or special purpose vehicles, in which a fund’s more illiquid investments are parked in a separate account for a defined period of time and protected from investor withdrawals while the assets are being liquidated.
These restrictions have not been confined to the smaller funds – many of the largest and most prominent funds have reportedly imposed them. For hedge fund managers, these have been wrenching decisions to make, as their reputation vis-à-vis current and potential investors is all important. They have had to juggle a complex set of considerations, attempting to ensure their fund’s survival while avoiding discrimination against various constituencies within their client base. With liquidity in markets fast drying up and investors clamoring for cash back, they have had to face difficult dilemmas: Will allowing all of their eligible investors to redeem lead to a stampede? Will allowing all redemptions be unfair to remaining investors? Should redemption notices be taken at face value since many investors framed their redemption amounts as “worst-case scenarios,” to be modulated depending on how much redemptions they would get themselves?
There have been no easy answers. Many hedge funds have sweetened their restructuring by lowering either or both management and incentive fees. Hedge funds that were inflexible in accommodating investor requests for managed accounts or other special treatment during the bull market, have become much more accommodating by necessity. In parallel, the secondary market for hedge fund stakes has taken off – many investors blocked from redeeming from a hedge fund have been willing to sell their stake to other qualified investors at a discount. For those with the cash to invest, this could prove to be very attractive. They can benefit from the fee discount and inherit other investors’ high water mark – the point at which a hedge fund has recouped all of its losses and can start charging incentive fees, which could take years to reach.
Many investors in hedge funds are frustrated by the weak performance and by what often has been a unilateral imposition of restrictions on withdrawals. But to be fair, this is generally not a situation in which opportunistic hedge fund managers take advantage of the naiveté of their investors. Hedge fund investors tend to be sophisticated investors in their own right – by law, they need to be qualified by showing a high level of net worth or investable assets. That group includes high net worth individuals as well as pension funds, endowments, fund of funds, and other institutional investors. The legal restriction on the ability to invest in hedge funds has allowed hedge funds to be lightly regulated, as opposed to mutual funds, which are open to the wider public and as a result, highly regulated.
Hedge fund managers have framed their restructurings as extra-ordinary actions for extra-ordinary times. Even if they have been designed in good faith, they add to a list of investor frustrations. The Madoff scandal, the most spectacular ponzi scheme ever implemented in the hedge fund industry, having allegedly lost US$ 50 billion of investor funds, has further beaten down the reputation of an industry often faulted for its lack of transparency.
Why Such Weak Performance?
Hedge Fund Research estimates that 70 percent of hedge funds posted negative returns for the year. Hedge fund managers had the tools to take advantage of the financial crisis through their ability to short, but save for a few celebrated managers, most hedge funds were not well positioned for it. Why?
The Timing Challenge
The story of the systemic financial collapse is still unfolding. At a high level, the real estate bubble burst and the ensuing sub-prime meltdown triggered a credit crisis. This led to a loss of confidence in our financial system and its collapse following an old-fashioned “run on the bank.” The collapse of Lehman Brothers, and the U.S. government’s decision to let it fail, proved cataclysmic – leading to losses in the commercial paper market and panicked withdrawals from money market funds, heretofore considered a near-riskless instrument. Negative yields on short term U.S. Treasuries vividly illustrated the dramatic flight to safety. The financial crisis eventually fed into the real economy, leading to a major drop in U.S. consumer spending and rising unemployment.
A crisis born in the developed world quickly spread to the rest of the world. Many had argued that decoupling would allow the fast growing Asian countries to be more resilient in the face of a developed world slow down – but the linkage between U.S. consumer and Asian exports and the global nature of the credit contraction proved overwhelming.
The collapse of the real estate bubble and the sub-prime crisis sparked the calamitous chain reaction but were not the underlying cause – global macro-economic imbalances underpin this economic crisis. A persistent and arguably unsustainable U.S. current account deficit has been offset by current account surpluses in Asian countries, particularly China. A common interpretation holds that the United States has been living beyond its means, borrowing from abroad to fund its consumption-led growth. China has been content to fund U.S. purchases of its manufacturing exports and accumulate foreign exchange reserves in the process. A byproduct of these capital flows came in the form of cheap credit available to U.S. consumers from surplus countries like China – an important enabler of the real estate asset bubble.
For all the talk about the current economic crisis being a “once in a lifetime event,” Scott Bessent makes the compelling argument that this is simply an “old-fashioned boom and bust story.” By this interpretation, excessive behaviors are driven by market psychology, alternating between periods of unhinged greed supported by trust in the markets and periods of fear-driven retrenchments and mistrust of the markets. The formidable scale of the asset bubble and of the leverage in the system made the implosion that much greater.
Many hedge fund managers agreed with the alarmist arguments made in the past several years by economists such as Nouriel Roubini and Stephen Roach but few appear to have positioned their portfolios accordingly. Determining the tipping point when large unsustainable macro-economic balances trigger a chain of events leading to a concrete crisis is made that much more challenging by the fact that getting the timing right is as important as getting the story right. Many prominent hedge fund managers imploded in 2000, having been prescient about the dot-com and equity bubbles but having acted too early on it. A few celebrated fund managers, most prominently John Paulson, got both the story of our current crisis and the timing right – but by and large, they were few.
The Asset-Liability Mismatch
One type of mismatch was discussed – just as hedge fund investors dramatically increased demands for withdrawal, the liquidity of these hedge funds’ investments dried up. The forced selling exacerbated their weak returns, even if gates and side pockets mitigated the effects.
Hedge funds had an additional problem going into the crisis – many of them had a significant mismatch between the liquidity of their long and their short positions. Paradoxically, this is a by-product of the industry’s success and tremendous growth over the past few years. According to Hedge Fund Research, AUMs grew from US$ 39 billion in 1990 to a peak of US$1.9 trillion by the middle of 2008. The number of hedge funds also grew dramatically, from 530 in 1990 to a peak of more than 7,600 by 2007 – over 10,000 when including fund of funds. The space has become much more crowded, making arbitrage opportunities tougher to capture. Many hedge funds have had to migrate toward more illiquid investment opportunities in order to generate attractive returns. This has resulted in portfolios with increasingly illiquid long positions offset by short positions that have had to remain liquid given sizable “borrow” is only available in the most highly traded securities. This worked fine during the bull market. Once the cycle turned, hedge funds found themselves with long positions whose liquidity rapidly dried up, leading to greater declines in value than their corresponding shorts.
In the same vein, certain common long and short positions were heavily favored by hedge funds, morphing into what several investment banks identified as “crowded trades.” Those positions significantly underperformed markets in the fourth quarter of 2008 as hedge funds attempted to unwind their positions at the same time. Crowded trades are also believed to have significantly hurt hedge funds with quantitative strategies in 2007, leading to steep losses for industry leaders such as Goldman Sachs’ Alpha Fund and Renaissance Technologies.
Shifts in the Hedge Fund-Prime Broker Relationship
Other factors conspired to worsen hedge fund performance. As massive deleveraging became a necessity throughout the financial system, hedge funds found themselves not only answering increasing investor demands but also facing closer scrutiny by their prime brokers. Prime brokerage units of investment banks act as a centralized securities clearing facility for hedge funds, enable them to leverage their positions, and offer them securities to be borrowed for short positions. They often develop a close relationship with hedge fund clients, some of which they were instrumental in launching. As the crisis unfolded during the fall of 2008, hedge funds were asked to post higher collaterals against their positions, causing them to deleverage. These more stringent capital requirements came through as declines in returns and client outflows hit certain trigger levels, usually defined as part of pre-agreed arrangements. For some types of securities trading particularly poorly such as convertible bonds, prime brokers requested 100 percent collateral. The close-knit relationship between hedge funds and their prime broker turned uncomfortable at times.
Counter-party risk came to the fore once Lehman Brothers declared bankruptcy. Many hedge funds that had a prime brokerage relationship with Lehman were able to take their balances out before the collapse. Those who did not became mired in the bankruptcy process. Prime brokers typically earn interest by lending out hedge fund assets in the repo market, a process called rehypothecation. The Lehman collapse brought to light the fact that depending on the jurisdiction hedge funds could be in practice unsecured creditors, leading to outright losses.
Consequently, hedge funds have sought to establish a greater number of prime brokerage relationships, a process of counter-party risk diversification that was already under way. As part of that process, an increasing share of prime brokerage business has been going to the more established deposit-taking banks.
Core to the Systemic Failure
Hedge funds did not ignite the current economic crisis. And as opposed to the major banks, hedge funds have not necessitated a government rescue, nor have we seen, at least up to now, the collapse of a hedge fund major enough to stir talk of a systemic risk event.
But the role and impact of hedge funds has significantly changed over time. They are no longer opportunistic players sitting at the periphery – their size and impact put them firmly at the core of the financial system. And while they did not trigger the crisis, they arguably accelerated it and perhaps even exacerbated it. By being part of an increasingly complex and sophisticated shadow banking system, they helped propagate financial products such as collateralized debt obligations (CDOs). They were active in the mortgage-backed security market that constituted the eye of the storm. They also added leverage to the system, increasing volatility during the crisis, and prompting George Soros to make the point in his recent U.S. Congressional testimony that hedge funds were “an integral part of the bubble.” Liquidations forced by investor redemptions and the necessity to deleverage also put further pressure on the markets.
Shorting by hedge funds of major financial institutions may have been self-validating, eventually affecting the fundamentals of these institutions. As the share price of Lehman Brothers steeply declined and credit default swaps (CDS) shot up, panicked institutions took their balances out, weakening its capital base and making its survival more uncertain.
1 comment:
The Future of Hedge Funds
Hedge funds took a beating last year, in their books but also in the press where they were lambasted for their opaque business practices.
JC de Swaan, Princeton University
13 March 2009
What a difference a year makes. Between 1989 and the end of 2007, hedge funds returned an annual average of 14 percent, with only one down year in 2002 when global markets plummeted 21 percent. That year and only that year hedge funds logged a negative average return of 1.5 percent.
By that measure, 2008 was cataclysmic. Last year, hedge funds returned negative 18 percent on average, according to Hedge Fund Research, with poor performance pervasive across almost all strategies. Only global macro strategies and funds that had a short bias ended up in the green. The other lost big, of which the biggest was Convertible Arbitrage at negative 35 percent.
In assessing the industry’s performance, Scott Bessent, a Senior Managing Director at Protégé Partners and a lecturer in economic history at Yale University, highlights two salient questions: What were investors’ expectations? And what did their hedge fund allocation replace in their portfolio?
Hedge funds are structured, and are pitched to investors, as absolute return investment vehicles – their ability to go both long and short and their relatively flexible investment mandates are supposed to enable them to make money in up-markets and down-markets, a characteristic often embedded in their marketing pitch. By the same token, their compensation is structured on an absolute-return basis – in addition to their management fees set as a percentage of assets under management (AUM), they receive incentive fees as a percentage of profits, starting at the first dollar of profit rather than at profits above any kind of benchmark.
The question regarding what hedge fund allocation typically replaced is harder to address. If hedge funds solely replaced equities in a portfolio, there would be more of a case for hedge funds’ outperformance in 2008. But that is debatable. Ever since Yale University’s David Swensen led the way by aggressively, and successfully, investing in alternative assets such as hedge funds, endowments and many other institutional investors have followed, resulting in a shift in portfolio compositions away from both equities and fixed income, toward these alternative assets.
Deep Restructuring
The Lehman Brothers bankruptcy and the ensuing collapse of the developed world’s financial system led to a massive acceleration in redemption demands from hedge fund investors, who, like all other participants in capital markets, were starved for liquidity. Quiet negotiations and testing of the waters by hedge funds in early Fall 2008 gave way to, often leaked, letters to investors in October and November and a period of time when announcements of major fund restructuring – typically imposing some sort of restriction on fund withdrawals – surfaced on a quasi-daily basis.
Recent estimates suggest that managers representing as much as half of the industry’s assets under management have imposed restrictions. These have taken the form of either “gates,” which temporarily disallow investors any fund withdrawals, or side-pockets or special purpose vehicles, in which a fund’s more illiquid investments are parked in a separate account for a defined period of time and protected from investor withdrawals while the assets are being liquidated.
These restrictions have not been confined to the smaller funds – many of the largest and most prominent funds have reportedly imposed them. For hedge fund managers, these have been wrenching decisions to make, as their reputation vis-à-vis current and potential investors is all important. They have had to juggle a complex set of considerations, attempting to ensure their fund’s survival while avoiding discrimination against various constituencies within their client base. With liquidity in markets fast drying up and investors clamoring for cash back, they have had to face difficult dilemmas: Will allowing all of their eligible investors to redeem lead to a stampede? Will allowing all redemptions be unfair to remaining investors? Should redemption notices be taken at face value since many investors framed their redemption amounts as “worst-case scenarios,” to be modulated depending on how much redemptions they would get themselves?
There have been no easy answers. Many hedge funds have sweetened their restructuring by lowering either or both management and incentive fees. Hedge funds that were inflexible in accommodating investor requests for managed accounts or other special treatment during the bull market, have become much more accommodating by necessity. In parallel, the secondary market for hedge fund stakes has taken off – many investors blocked from redeeming from a hedge fund have been willing to sell their stake to other qualified investors at a discount. For those with the cash to invest, this could prove to be very attractive. They can benefit from the fee discount and inherit other investors’ high water mark – the point at which a hedge fund has recouped all of its losses and can start charging incentive fees, which could take years to reach.
Many investors in hedge funds are frustrated by the weak performance and by what often has been a unilateral imposition of restrictions on withdrawals. But to be fair, this is generally not a situation in which opportunistic hedge fund managers take advantage of the naiveté of their investors. Hedge fund investors tend to be sophisticated investors in their own right – by law, they need to be qualified by showing a high level of net worth or investable assets. That group includes high net worth individuals as well as pension funds, endowments, fund of funds, and other institutional investors. The legal restriction on the ability to invest in hedge funds has allowed hedge funds to be lightly regulated, as opposed to mutual funds, which are open to the wider public and as a result, highly regulated.
Hedge fund managers have framed their restructurings as extra-ordinary actions for extra-ordinary times. Even if they have been designed in good faith, they add to a list of investor frustrations. The Madoff scandal, the most spectacular ponzi scheme ever implemented in the hedge fund industry, having allegedly lost US$ 50 billion of investor funds, has further beaten down the reputation of an industry often faulted for its lack of transparency.
Why Such Weak Performance?
Hedge Fund Research estimates that 70 percent of hedge funds posted negative returns for the year. Hedge fund managers had the tools to take advantage of the financial crisis through their ability to short, but save for a few celebrated managers, most hedge funds were not well positioned for it. Why?
The Timing Challenge
The story of the systemic financial collapse is still unfolding. At a high level, the real estate bubble burst and the ensuing sub-prime meltdown triggered a credit crisis. This led to a loss of confidence in our financial system and its collapse following an old-fashioned “run on the bank.” The collapse of Lehman Brothers, and the U.S. government’s decision to let it fail, proved cataclysmic – leading to losses in the commercial paper market and panicked withdrawals from money market funds, heretofore considered a near-riskless instrument. Negative yields on short term U.S. Treasuries vividly illustrated the dramatic flight to safety. The financial crisis eventually fed into the real economy, leading to a major drop in U.S. consumer spending and rising unemployment.
A crisis born in the developed world quickly spread to the rest of the world. Many had argued that decoupling would allow the fast growing Asian countries to be more resilient in the face of a developed world slow down – but the linkage between U.S. consumer and Asian exports and the global nature of the credit contraction proved overwhelming.
The collapse of the real estate bubble and the sub-prime crisis sparked the calamitous chain reaction but were not the underlying cause – global macro-economic imbalances underpin this economic crisis. A persistent and arguably unsustainable U.S. current account deficit has been offset by current account surpluses in Asian countries, particularly China. A common interpretation holds that the United States has been living beyond its means, borrowing from abroad to fund its consumption-led growth. China has been content to fund U.S. purchases of its manufacturing exports and accumulate foreign exchange reserves in the process. A byproduct of these capital flows came in the form of cheap credit available to U.S. consumers from surplus countries like China – an important enabler of the real estate asset bubble.
For all the talk about the current economic crisis being a “once in a lifetime event,” Scott Bessent makes the compelling argument that this is simply an “old-fashioned boom and bust story.” By this interpretation, excessive behaviors are driven by market psychology, alternating between periods of unhinged greed supported by trust in the markets and periods of fear-driven retrenchments and mistrust of the markets. The formidable scale of the asset bubble and of the leverage in the system made the implosion that much greater.
Many hedge fund managers agreed with the alarmist arguments made in the past several years by economists such as Nouriel Roubini and Stephen Roach but few appear to have positioned their portfolios accordingly. Determining the tipping point when large unsustainable macro-economic balances trigger a chain of events leading to a concrete crisis is made that much more challenging by the fact that getting the timing right is as important as getting the story right. Many prominent hedge fund managers imploded in 2000, having been prescient about the dot-com and equity bubbles but having acted too early on it. A few celebrated fund managers, most prominently John Paulson, got both the story of our current crisis and the timing right – but by and large, they were few.
The Asset-Liability Mismatch
One type of mismatch was discussed – just as hedge fund investors dramatically increased demands for withdrawal, the liquidity of these hedge funds’ investments dried up. The forced selling exacerbated their weak returns, even if gates and side pockets mitigated the effects.
Hedge funds had an additional problem going into the crisis – many of them had a significant mismatch between the liquidity of their long and their short positions. Paradoxically, this is a by-product of the industry’s success and tremendous growth over the past few years. According to Hedge Fund Research, AUMs grew from US$ 39 billion in 1990 to a peak of US$1.9 trillion by the middle of 2008. The number of hedge funds also grew dramatically, from 530 in 1990 to a peak of more than 7,600 by 2007 – over 10,000 when including fund of funds. The space has become much more crowded, making arbitrage opportunities tougher to capture. Many hedge funds have had to migrate toward more illiquid investment opportunities in order to generate attractive returns. This has resulted in portfolios with increasingly illiquid long positions offset by short positions that have had to remain liquid given sizable “borrow” is only available in the most highly traded securities. This worked fine during the bull market. Once the cycle turned, hedge funds found themselves with long positions whose liquidity rapidly dried up, leading to greater declines in value than their corresponding shorts.
In the same vein, certain common long and short positions were heavily favored by hedge funds, morphing into what several investment banks identified as “crowded trades.” Those positions significantly underperformed markets in the fourth quarter of 2008 as hedge funds attempted to unwind their positions at the same time. Crowded trades are also believed to have significantly hurt hedge funds with quantitative strategies in 2007, leading to steep losses for industry leaders such as Goldman Sachs’ Alpha Fund and Renaissance Technologies.
Shifts in the Hedge Fund-Prime Broker Relationship
Other factors conspired to worsen hedge fund performance. As massive deleveraging became a necessity throughout the financial system, hedge funds found themselves not only answering increasing investor demands but also facing closer scrutiny by their prime brokers. Prime brokerage units of investment banks act as a centralized securities clearing facility for hedge funds, enable them to leverage their positions, and offer them securities to be borrowed for short positions. They often develop a close relationship with hedge fund clients, some of which they were instrumental in launching. As the crisis unfolded during the fall of 2008, hedge funds were asked to post higher collaterals against their positions, causing them to deleverage. These more stringent capital requirements came through as declines in returns and client outflows hit certain trigger levels, usually defined as part of pre-agreed arrangements. For some types of securities trading particularly poorly such as convertible bonds, prime brokers requested 100 percent collateral. The close-knit relationship between hedge funds and their prime broker turned uncomfortable at times.
Counter-party risk came to the fore once Lehman Brothers declared bankruptcy. Many hedge funds that had a prime brokerage relationship with Lehman were able to take their balances out before the collapse. Those who did not became mired in the bankruptcy process. Prime brokers typically earn interest by lending out hedge fund assets in the repo market, a process called rehypothecation. The Lehman collapse brought to light the fact that depending on the jurisdiction hedge funds could be in practice unsecured creditors, leading to outright losses.
Consequently, hedge funds have sought to establish a greater number of prime brokerage relationships, a process of counter-party risk diversification that was already under way. As part of that process, an increasing share of prime brokerage business has been going to the more established deposit-taking banks.
Core to the Systemic Failure
Hedge funds did not ignite the current economic crisis. And as opposed to the major banks, hedge funds have not necessitated a government rescue, nor have we seen, at least up to now, the collapse of a hedge fund major enough to stir talk of a systemic risk event.
But the role and impact of hedge funds has significantly changed over time. They are no longer opportunistic players sitting at the periphery – their size and impact put them firmly at the core of the financial system. And while they did not trigger the crisis, they arguably accelerated it and perhaps even exacerbated it. By being part of an increasingly complex and sophisticated shadow banking system, they helped propagate financial products such as collateralized debt obligations (CDOs). They were active in the mortgage-backed security market that constituted the eye of the storm. They also added leverage to the system, increasing volatility during the crisis, and prompting George Soros to make the point in his recent U.S. Congressional testimony that hedge funds were “an integral part of the bubble.” Liquidations forced by investor redemptions and the necessity to deleverage also put further pressure on the markets.
Shorting by hedge funds of major financial institutions may have been self-validating, eventually affecting the fundamentals of these institutions. As the share price of Lehman Brothers steeply declined and credit default swaps (CDS) shot up, panicked institutions took their balances out, weakening its capital base and making its survival more uncertain.
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