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September 10, 2007
Dirty little secrets of hedge funds
One reason hedge funds are so popular is their ability to protect against market downturns, usually through short-selling or options-related strategies. This gives them a distinct advantage over most mutual funds, which are limited to "long-only" investment strategies that place them at the mercy of wild market swings.
But for most of the past decade, hedge funds have become less about "hedging" and more about leveraging assets to produce outsized returns. This addiction to leverage, combined with questionable accounting techniques, is now coming home to roost for many hedge funds.
Over the past few months, hedge fund blowups have become commonplace. From behemoths like Sowood Capital Management (which lost $1.5 billion in investor assets) and Bear Stearns (which lost a similar amount), to smaller niche players managing "only" millions instead of billions, it is a rare day when at least one previously successful fund doesn't close its doors for good.
How can this happen, you might ask? After all, aren't hedge funds managed by the best and brightest investing minds in the world?
Well, there are two dirty little secrets in the hedge fund world that most investors never see, and they are called "leverage" and "mark-to-market accounting." And while they might sound innocuous enough, when combined they are as dangerous as fire and gasoline.
Leverage is simply a fancy word for borrowing. While almost all of us borrow money, few do so as prodigiously as hedge funds. Many of these funds leverage their asset base through margin loans by five, 10, or even 20 times its actual value - allowing a $100 million hedge fund to control more than a billion dollars in investments.
When done correctly, this leverage allows them to potentially earn huge returns for their clients. It also puts them right in the cross hairs of a market decline that could decimate their portfolio. For example, a portfolio that is leveraged 20:1 need only experience a 5 percent loss to wipe out the entire asset base, forcing the fund to close and leaving the fund's investors with nothing.
"Mark-to-market," on the other hand, is an accounting concept that simply means that at the end of every day, an investment is "marked" to its current fair value.
Seems simple enough, doesn't it? Unless you are a hedge fund. Many hedge funds, particularly those dabbling in illiquid assets (such as sub-prime mortgage debt), simply hold their assets on the books at cost.
While this approach works in a strong market environment, problems arise when, like now, the underlying market for these assets collapses. At some point these hedge funds have to come clean with their investors and report their assets at fair value, which in many cases will be only a fraction of their original cost. When that happens, their investors will be in for quite a shock.
Now combine that leverage with the concept of "mark-to-market" accounting and things get ugly.
Assume when "Hedge Fund A" reports its real net asset value, it receives redemption calls from some of its unhappy investors or is asked to provide additional capital as collateral for its margin loan - something that is happening all over the world today. It has to sell some of its illiquid assets to raise cash. But as you may have guessed, there are no ready buyers for these assets, so the fund has to either sell other things in its portfolio (such as publicly traded stocks) or take pennies on the dollar for its -illiquid assets (assuming it can find a buyer at all).
Not surprisingly, this story ends poorly for everyone. As the fund's asset base dwindles, more investors scramble to redeem their shares, more liquidations are necessary, and the market continues to soften. Eventually the fund is forced to close its doors, write a mea culpa letter to its remaining shareholders and shut down for good.
We have seen this happen repeatedly over the past few months. Unfortunately, this may only be the first inning of a very sad and expensive game in which billions of dollars in investment capital will be wiped out. While this is ultimately healthy for the markets as a whole, it will be a tragedy for some hedge fund investors caught in the middle.
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Posted by su at September 10, 2007 11:51 AM