What have hedge funds done to navigate the maze of the credit crisis?
Over the past year we have witnessed an unprecedented crisis for hedge funds. Assets under management have been in free fall, partly due to poor performance, partly due to fleeing assets trying to rescue some value, or trying to meet obligations elsewhere, primarily in real estate or private equity.
To understand what hedge funds have done to survive the credit crisis, we have to look at what happened during the crisis. Money had been pouring into hedge funds over the course of several years, doubling the assets under management in half a decade. Hedge funds had been able to manage investors’ money while at the same time charging handsomely for the service. This opportunity to become very rich attracted many long-only managers to start up new hedge funds. But one thing that was forgotten during the good times was that hedge funds need to be managed in a different way to long-only funds. Hedge funds aim to deliver positive results even when markets are down, or at least maintain a big portion of the value. Otherwise an investor could buy a cheaper long-only fund. This craft is not easy, which the world was soon to see.
Rapid growth
The hedge fund community grew rapidly but it was adding skills that were not wanted. When the systemic credit crisis hit the markets in the autumn of 2008, many hedge funds lacked the ideologies and the tools needed to deal with risks skyrocketing and correlations rapidly rushing towards one.
The tools used were usually value-at-risk, aiming to predict future probabilities of return distributions. With probabilities of 95%, or even 99%, the problem was that 1%-5% of possible outcomes were still uncovered. Many managers invested money as if these 1%-5% of possible outcomes were never going to occur. When the ‘black swans’ did arrive, in the autumn of 2008, managers found themselves in trouble, big time.
Market-wise, hedge funds needed to become creative to be able to provide returns good enough for investors to stay invested. Many participants such as hedge funds, prop desks, other institutions and private investors were entering the hedge fund market, for example via hedge fund of funds, so there was big competition about which trades to make. The trades became increasingly complicated as a result of managers’ efforts to provide return. In this process many hedge fund managers simply forgot about liquidity. They were used to managing the hedge funds while having capital inflows, which had made the liquidity issue seem irrelevant.
But, as we all know, the credit crisis proved them dead wrong. Liquidity was seen to be one of the most vital factors to take into account while managing investors’ money. Experience from behavioural finance tells us that people act like a herd when investing money, and when the crisis hit, people wanted out. Hedge funds were sitting on complicated trades that in some cases could take months or even years to materialise. Managing a hedge fund in that environment became almost impossible.
And, if this was not enough for hedge fund managers, counterparty risk also became apparent. Lehman defaulted and many other primary brokers were on the brink of extinction. Investors at the time were wondering who could be trusted with their money.
How to survive in this environment
Many hedge funds are now out of business. Those that succeeded managed to address the liquidity issue and the way they make trades. Instead of having complicated trades, they use simpler constructions, often involving only one long and one short trade. A back-to-basics approach is now back in fashion, and rightly so.
One thing making back-to-basics possible is that there are feasible opportunities out there now that the market is no longer over-crowded. Hedge funds do not even have to use that much leverage today to take advantage of these opportunities.
Hedge funds have also addressed the gearing issue since leverage can represent a huge risk for the hedge fund. They are painfully aware of how suddenly it can be pulled away by counterparties, resulting in closures.
We also see that hedge funds that previously used various OTC derivatives are trying to mitigate counterparty risk by making greater use of exchange-traded platforms. Improved liquidity and transparency are results of that.
What do investors need to see?
The first and foremost obligation should be towards clients – hedge funds need to secure their investments as much as possible. Therefore hedge funds need to behave in a certain manner for advisers to be willing to risk clients’ money in them.
‘Understandability’ is very important. Investors need to understand what funds invest in, and from where the returns are generated and how. They also need hedge fund managers to understand what they are doing. Manager due diligence is therefore very important.
Apart from ‘understandablity’, investors want to see good liquidity within the hedge fund, as well as the trading schemes for investors. Furthermore, they want to see proven risk handling, clear risk mandates and basically an institutional set-up.
Hedge funds meeting these criteria will probably prosper going forward while hedge funds that do not will continue to have a tough time.
Strategy by strategy
At the strategy level, there are some differences. Strategies working with more liquid instruments are preferred. These strategies include global macro and CTA. Strategies which are easily understood are also preferred. Equity L/S and parts of fixed income would fit this description, even though some fixed income strategies are sensitive to liquidity and credit funding.
When it comes to merger arbitrage, the inherent asymmetric return distribution is a disadvantage. They have a quite small return objective but if something goes wrong, the cost can be very high.
Distressed investing often gives good opportunities to take advantage of mispricing when companies file for bankruptcy; the problem here is that these trades often take a while to materialise making this a potential liquidity issue.
Richard Lundquist, portfolio strategist, SEB Private Banking
