« Dirty little secrets of hedge funds | Main | Hedge Funds down 1.8% in Aug 07 »
September 10, 2007
Subprime crisis tests hedge funds
You could say that this summer's credit crunch was a chance to see the hedge fund emperors without their clothes.
As banks around the world tightened access to money, on concern that borrowers' collateral was impaired by exposure to subprime loans, some of the highest-profile upsets were reported in the $1.7 trillion hedge fund industry. As these secretive and unregulated funds scrambled to raise cash and dump tradable assets, tales of double-digit losses, implosions and bankruptcies replaced Paris Hilton in the headlines.
The crunch, which is still working its way out of the world's financial system, raised big questions about the viability of some hedge fund strategies in the absence of easy money, which had encouraged fund managers to take on increasing levels of leverage and risk.
Whether there will be a major shakeout is still an open question. For August, the Hedge Fund Research index, which uses 75 component funds weighted to represent 7,600 single-management hedge fund strategies, was down 2.5 percent after sinking as much as 4.5 percent at midmonth.
Ken Heinz, president of Hedge Fund Research in Chicago, noted a "greater dispersion between strategies and between funds." It is a time, he said, when funds "have the opportunity to distinguish themselves" from the pack.
It is also an opportunity for investors to get some insight into an industry whose activities are often cloaked in secrecy and which has
wandered far from its original purpose of hedging volatility.
Before hedge funds were opened to the merely affluent, they were the near-exclusive purview of the very well off - those with at least $1 million to invest and $1 million net worth. So one place to look for clues to evaluate hedge fund strategies is private bankers, who have advised wealthy clients for decades on hedge fund selection as part of an overall investment strategy.
While private bankers tend not to divulge for free the specific advice they give their high-paying clients, they generally agree that one of the major tenets for hedge fund selection is that quality is not defined solely by performance. What they look for first is a clear sense of strategy and purpose, as well as a level-headed approach to risk.
"When we invest in a hedge fund, the first and most important point for us is the people. Then we ask, 'What is your strategy?' " said Christof Reichmuth, chief executive of Reichmuth Private Bankers in Lucerne, Switzerland. "Then we want to know, 'In what environment does your strategy work, and when does it have a headwind?' "
Performance, he said, comes into the picture afterward. Reichmuth's two funds of hedge funds, Reichmuth Matterhorn and Reichmuth Himalaja, were the two best-performing funds of funds in Switzerland in the year ending June 30, according to Neuer Zürcher Zeitung, a top Swiss daily.
While some investors associate hedge funds with risk-taking gurus like George Soros, the goal of the father of the hedge fund, Arthur Winslow Jones, back in the 1950s, was very different: to avoid market risk and still produce outstanding results by hedging his long positions with significant short positions, typically using modest leverage.
"Most private clients feel hedge funds are a way to risk more money," said Daniel Pinto, co-founder and managing director of Stanhope Capital, a London-based firm that manages the affairs of European families with very large fortunes. "They do not understand that hedge funds are supposed to be a protection for your portfolio. They are a buffer against volatility. They are not supposed to perform at 30 and 40 percent."
Alfred Roelli, head of research at Pictet, a private bank in Geneva, remembers when Soros and Michael Steinhardt, founder of Steinhardt Partners and one of the most successful of the early hedge fund managers, employed a mix of shrewd intuition and risk control. Steinhardt's fund returned 24 percent annually compounded over 28 years.
"They took risks," Roelli said, "but they were calculated risks that worked in 99 percent of cases."
Today's bandwagon investment managers, Roelli said, are far more reckless. "From 200 hedge funds to between 6,000 and 10,000?" he asked. "There are simply not that many people qualified to run a hedge fund."
Mention the computerized quantitative or black-box methodology that hedge fund math whizzes embrace, and private bankers grow queasy.
"We won't touch them," Pinto said. "The programs are quite sophisticated. They do work in stable markets, but they have a fundamental weakness. There is no room for judgment. When markets behave erratically - as they have recently - the inability to use common sense to make investment decisions, combined with a high level of leverage, is a recipe for disaster."
The collapse of Long-Term Capital Management in 1998 proves his point. The recent problems of some of the best known multibillion-dollar "quant" funds are a stark reminder.
"We have had pressure from some clients" to buy quant funds for their accounts, Pinto said. "We say, 'If you want to buy it, you won't do it through us.' "
When the pressure for higher returns is met by an equally human desire to believe what one wants to believe, the result can be disastrous.
Take the penchant for CDOs, or collateralized debt obligations. These are securities comprising a bundle of assets that may include loans, mortgages and bonds with different levels of risk and a variety of yields. They are then divided into segments with different default characteristics.
As it became more difficult to make money in bonds, many hedge fund managers turned to these more complicated debt instruments. But many CDOs are stuffed with subprime mortgages that are now beginning to default at a far higher rate than originally predicted. It is the inability to assess the value of CDO portfolios that caused the current liquidity crisis and the bankruptcy of several hedge funds.
William Pool, president of the Federal Reserve Bank of St. Louis, Missouri, speaking in July after several hedge fund disasters, commented: "It is surprising to me that sophisticated capital market investors willingly purchased securities backed by such poorly underwritten mortgages."
As the credit market swung from greed to fear this summer, some hedge fund investors began asking questions. Pinto said Stanhope's clients reflected concern about two themes. First it was, "Tell me about my CDO exposure. What do I have?' "
The other theme was liquidity. Investors worried about whether they would be prevented from redeeming their investment. Pinto pointed out that hedge fund gates - limits to the total amount of assets that can be redeemed - could prevent forced selling at fire-sale prices.
However, he said, the really unexpected event came from so-called dynamic money market funds, which offer enhanced return over money market rates by investing a small portion in riskier credit instruments.
In France, several funds that held CDOs temporarily closed, confessing their inability to value certain securities as the credit market froze. "We were not touched," Pinto said. "But it made us extremely careful about the dynamic money market products we are using."
Stanhope is now recommending that investors buy equities, especially in Europe, where Pinto finds the market, at 13 times earnings, undervalued. Even the United States, which trades at 15 times earnings, is attractive, he said.
"The world economy is healthy, so we don't expect a sudden collapse" in earnings, he said. "And the fact that interest rates are going up is not going to affect the larger corporations. They have a lot of cash."
Pictet has also raised its recommended allocation to equities. "The bond market has become more and more nontransparent," Roelli said. "Relative to equities, bonds are riskier."
Reichmuth is one hedge fund manager that profited from the turmoil. Anticipating the subprime problem as long as a year ago, as spreads between top-quality and low-quality debt issuers converged, he found three hedge funds that shorted the subprime market, one of which hit a home run and helped his funds produce a 4 percent gain in July. In another tactic to hedge long equities, Reichmuth shorted an index of broker-dealers, whose stocks tended to fall faster than the market over all. Reichmuth is also currently positive on Asia and on the yen.
But while short-term moves to catch trends are what smart hedge fund managers do best, individual investors probably do better with a long-term view. The current market turmoil is "having a massive effect on every asset class," Pinto said, "but people shouldn't throw in the towel and say everything is risky. People should keep cool heads and see where there are values."
-International Herald Tribune-
Posted by su at September 10, 2007 12:06 PM