Thursday, November 6, 2008

Back to the (Hedge Fund) Future

So the hedge funds are struggling.

Name the fund, pick the strategy; it's struggling. It doesn't matter if you're an academic playing the curve (Myron Scholes' Platinum Grove) or a contrarian macro-fund manager (Peter Thiel's Clarium).

Don't get me wrong here - I'm not suggesting all hedge funds are equal. Indeed some are more equal than others. The access to funding and execution resources may be material differences (although these funds often tend to be more highly leveraged on the back of their support system, and in this deleveraging nightmare are subsequently underperforming their peers despite the availability of this backing - see for example Highbridge Capital, Goldman's Global Alpha, UBS's Dillon Read, and various Citigroup hedge funds).

And despite all the blah blah about 2 & 20 fees being problematic, let's face it - it's not the fees causing 20%, 50% or 80% losses. And it's not regulation either: almost by definition, hedge funds are not having to mark-to-market (MtM) their illiquid/hard-to-value securities. (I'm not strictly correct here, particularly for Och-Ziff, Blackstone and Fortress, which are publicly traded.)

So what is it?

If you're a hedge fund, you're net long; if you're trading OTC securities, you're subjected to comparatively massive bid-offer spreads; and if you're levered, you're dependant on the banks for financing.

What does this all mean?

As a hedge fund you've got capital and you're being paid to put that capital to work. Even if you're long/short equity, you're typically net long at least the same amount as your capital, unless you're holding substantial portions in cash. As an investor in a hedge fund, you don't want your manager charging you hedge fund fees to invest in cash. You can do that yourself. For free.

In a down-cycle, the equity hedge fund manager would have to be a pretty impressive stock picker and seller just to cut even. It's tough to be consistently correct, especially in a fear-driven, volatile market.

But it's the fixed-income hedge funds that have to deal with large bid-offer spreads on OTC-traded securities to cover the market's illiquidity premium/discount and the intermediary's (bank's/broker's) risk that it can't off-load the security and may become subjected to downside MtM pricing risk. You have to be pretty good just to come out even.

And then there's that little issue of leverage. With hedge funds going under all over the place, the banks are understandably being ultra careful about who they lend to (not to mention spending extraordinary amounts of time reverse-engineering the value of their clients' portfolios, to get a better idea of any pending client defaults). If you're looking like defaulting, your haircuts are going to go out of the roof and/or they may draw their line completely. So your hedge fund's default probability -- or more accurately your leverage providers' perceptions of your default probability -- adds an additional burden to the deleveraging nightmare (see our piece Illiquidity: Self-perpetuating Phenomenon). But a blog on this will have to wait for another day...

Where to from here?

We can't pretend to have all the answers; let's call these guesses for now:

Similar to the increased regulatory demands Goldman and Morgan now face as bank holding companies (subject to the Fed), hedge funds are suffering from increased scrutiny and, with it, criticism of their investments and operations - not to mention decreasing investor confidence and redemptions skittishness.

(Even New York City Mayor Michael Bloomberg endorsed the U.S. Treasury's recent recommendation of a new "market stability regulator," that would be able to step in when markets got out of control, having oversight over firms that generally escape regulation, like hedge funds and private equity firms.)

In the absence of "free reign" we envision the natural progression (particularly among the larger hedge funds) towards advisory or asset-management-esqe businesses (think PIMCO, Blackrock): the move away from bank dependency to the unleveraged world of asset management seems an appealing option; alternatively, the move into the advisory space is quite cheap and relatively swift a process, especially as they already have the expertise in-house.


Anonymous said...

makes a lot of sense, although just wonder, where the "smart and hungry" will go - there is no .coms to rip millions of bubbly dollars in the advisory business seems to me. also if LTCM's successfully opened/closed the third HF. as long as investors dont become smarter, why cant this pattern be repeated over and over

this is just playing devil's advocate, but your argument is great. El-Erian argued at a recent conference something along these lines.


In the end most of these hedge funds will crash.