November 2007

HEDGE FUNDS: Downward fall

A number of hedge funds didn’t survive by the market instability caused by the sub-prime crisis, begging the question: are they as robust as is commonly thought? By Kristen Paech 07_11_hedge_funds.jpgThe selling point of hedge funds, and the characteristic that allows them to justify their significant fees when compared with the long-only world, is largely their ‘absolute return’ tag. In essence, many hedge funds are marketed on their ability to make investors money even when markets are falling. Yet during the sub-prime related market dip, many hedge funds struggled to stay above water and even those with no exposure to sub-prime mortgage backed securities were hit by the contagion that spread across all of the financial markets.
Two hedge funds run by Bear Stearns and one managed by Australia’s Basis Capital have filed for bankruptcy and others run by Goldman Sachs, Cheyne Capital Management and Tykhe Capital have since run into trouble. The HFRI Fund Weighted Composite Index was down 1.3% in August, while the S&P 500 index was up 1.5%; however, a bounce-back in September saw the HFR index rise an estimated 2.98%. So was August just a blip on a fairly impressive track record for the hedge fund industry as a whole? Both managers and consultants are staunch in their defence. “The performance in August does not negate in any form or manner the absolute return mandate of the hedge fund industry,” says Taco Sieburgh, director of research at hedge fund consultancy Liability Solutions. Stephen Oxley, managing director of PAAMCO Europe, adds: “I really think it’s a mistake to isolate one or two months and try from that to make general conclusions about the longer term performance of these strategies. We now have a ten-year track record for hedge fund returns and if you look at them over the longer term they do justify their fees.”

Winners and losers
It’s worth mentioning that hedge funds made money in June and July when the S&P declined, and an exceptionally bad August has not significantly impaired the ample year-to-date returns. The HFR Fund Weighted Composite Index is up 9.14% year-to-date, while the HFR Fund of Funds Composite Index stands at 8.45%. Indeed, while on average hedge funds underperformed in August, funds that were set up specifically to take advantage of credit dislocation, such as the US$4.5bn Paulson Credit Opportunities Fund, have profited hugely. The fund, launched last year to bet against sub-prime, is reportedly up 410% year-to-date after soaring 26.67% in August, while a second fund, the $2.3bn Credit Opportunities II, rose 32% and is up 229.67% year-to-date.
“Those funds took a directional play on sub-prime, assuming there would be a sub-prime crisis and have made super normal returns,” says David Aldrich, a managing director at The Bank of New York Mellon. “The Paulson funds are great examples of how you can use hedge fund vehicles to profit from major moves in the market.”
But for all the big winners, there were just as many big losers. Some of the worst performing strategies included emerging markets, global macro, managed futures and event-driven funds, but perhaps the strategy that looked worst on a relative basis was long/short equity. “In August, a big part of the losses came from the equity long/short managers while the equity market was actually overall positive in August,” says Yannis Procopis, deputy CIO of CM Advisors.

Shake out
“There was a huge sell-off at the end of July, which continued into August, before recovering at the end if the month, and that hugely volatile environment proved very difficult for many equity long/short managers.”

There have been about 20 high-profile closures linked to mortgage-backed sub-prime directly, with Sentinel in Europe having a knock-on effect on others in the marketplace, including Capital Fund Management.

Donnacha Loughrey, portfolio manager, alternative investments at KBC Asset Management, expects to see some consolidation in the industry going forward.

“We still see the attrition rate in hedge funds running at about 10% per annum but some of the smaller hedge funds that are independent and have been hit hard by the tighter credit conditions will probably be bought by one of the larger investment banks or by a traditional fund management business, or simply close,” he says. “There’s going to be a shake out, more than the 20 or so funds we’ve seen close, but I’d expect that performance in September has probably eased a lot of the redemption fears that people were anticipating in November or December, so I wouldn’t expect a lot of failures from the broader hedge fund universe.” The nature of the instruments in which hedge funds invest further complicates the ability to valuate assets and positions until they are sold.

Sitting on losses
Julian Korek, a founding member of Kinetic, which provides accountancy and consultancy services to the investment management industry, comments: “The absence of liquidity means there’s no willing buyer of the instruments that many hedge funds are holding, and so it is hard to establish a price. Funds who have kept these instruments at book value or last counterparty valuation may be sitting potentially large losses, once a market for these instruments reappears. There may be many more skeletons in the cupboards of a lot of hedge funds.” When high net worth and institutional investors commit capital to hedge funds, they are fully aware of the risks that entail.
However, what the backlash over hedge fund returns during the sub-prime crisis has demonstrated is that it is less about how they performed on an absolute basis and more about how they performed relative to investors’ expectations. In this respect, it seems they fell well short of the mark. "They have performed better than traditional strategies – they’ve had less volatility and they have been able to demonstrate something of the hedge,” says Peter Harrison, CEO of MPC Investors. “However, they have been far too correlated and they have performed less well than most people expected they should do.”
The make-up of the fee structure for hedge funds is such that many funds now face months if not years without a performance fee. While many do not have a hurdle rate, and are rather measured against zero or cash, nearly all of them have high water marks. High water marks are measured annually and if a manager underperforms in one year, they have to make back the performance the following year before they can start charging a performance fee again. “The average fund wouldn’t have generated a performance fee in July or August because they’re probably about 3% below their high water mark, but depending on the strategy a lot of these funds can make that back quite quickly,” says Loughrey.
Procopis adds: “Even with the August losses, as an industry it’s still definitely above its high water mark from the beginning of the year. August was difficult but a lot of the losses were already made back in September.” But for those funds that suffered more severe losses, the sub-prime crisis may just be the death of them. “A lot of funds lost 20 or 30%, so they are now so far below their high water mark that it’s not worth carrying on,” says Harrison.
“This is the incentive structure working correctly; if you lose your clients’ money you don’t earn any fees until such time that you start making your clients money again.” ©  fe November 2007

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