Hedge funds take more than a trim

Date: Thursday, August 16, 2007
Author: Telegraph.co.uk

James Quinn explains how turbulent markets left computer-driven technology, used by managers to operate investment strategy, struggling to cope.

Masters of the Universe. The new investment bankers. Hedgies. Whatever name you choose to describe hedge fund managers, it is always a positive one. That was until last Thursday, when trading screens turned red across the globe and the latest whiz-kids on the block proved to be just as infallible as rest of the financial community.

The root of the problems lie in the US sub-prime mortgage market last year. As these high-risk home loans were diced and spliced into packages of collaterised debt obligation (CDO) and syndicated into various forms, few hedge fund managers saw the potential downside.

The first hint came earlier this year when Dillon Read Capital Management, UBS's hedge fund, was closed after running up losses stemming from the collapse of the sub-prime mortgage market. A few weeks ago the contagion spread to two high-profile Bear Stearns hedge funds.

Ironically, it is not in such credit strategy funds where the majority of the damage has been done. The real pain has been seen in hedge funds which technically offered investors a much safer ride. Quantitative funds - or "quants" - use algorithmic formulas to assess historical data and decide upon an investment strategy. Trading is driven by computers programmed by mathematical maestros.

On the plus side, quants remove the need for human emotion or logic. It keeps the costs down and profits up - often a quant fund managing hundreds of millions of pounds can be run by one or two managers, a computer expert and a few back office staff.

On the down side, when the markets turn swiftly and erratically, with little basis to historical performance, things can go badly wrong. This has been exacerbated by the see-saw effect taking place in some markets, with the quant technology not able to work out the recent historical market trend.

The reason the markets were taken by surprise is that, until now, there has been no downside. Funds such as Renaissance Institutional Equities - which could previously do no wrong - fell 8.7pc this month, and it was far from alone.

For the hedgies themselves, this has been a difficult time. "Of course it's painful," said one, who like so many others, asked not to be named. "But the long-term answer is there are equal amounts of pain and gain." Although quants may be having a tough time, others that tend to take much closer and more active management decisions, believed to include Paulson and Och-Ziff, have done well.

That view is reflected in recent data. The Credit Suisse/Tremont hedge fund index was flat for July - the last week of which was particularly tumultuous. Overall the index is up 8.7pc year-to-date, something that cannot be said for traditional equities. The statistics do not take into account the last two weeks - over which time it is possible, although not guaranteed, the index could have taken a negative turn.

It is often forgotten how heavily hedge funds rely on leverage. Typical quant strategies will have geared up between five and 10 times, so the falls were exacerbated five to 10 times.

That leverage comes from prime brokers, who in turn borrow the money on the open market. When banks failed to supply that liquidity last week, central banks, pushed by the European Central Bank, stepped in with fresh cash. At the same time, prime brokers started to make margin calls to their hedge funds clients. To meet these margin calls, hedge funds sold down assets. This triggered further shock waves as those unable to meet these calls had to be recapitalised or face being wound up.

The relationship between prime brokers and hedge funds has now changed for good. For the last few years, prime broking had been seen as one of the key departments within any investment bank, making money by charging for lending stock to hedge funds to allow shorting; by taking interest rate spreads on loans needed to buy equities or debt instruments; and by charging for settling transactions completed elsewhere. Prime broking is essentially a service department, and if the hedge fund industry slows somewhat, then so too will the work surrounding it.

Hedgies' relationship with investors has also been damaged. In the past 18 months, money placed in hedge funds has doubled but negative headlines will have served to only add to the at times jittery experience of those who invest in alternative asset classes.

Some will take fright and run. This will hit not just those who have made losses.

In most cases, hedge fund redemptions can be made on a quarterly basis with 45 days' notice. Yesterday was the final day for investors to withdraw funds for the September quarter end. The exact level of money being withdrawn will most likely never be known, although drips and drabs of information will no doubt leak out.

One London-based hedgie said: "Redemptions are always a factor, and of course, we're concerned. There will clearly be certain investors, such as the Swiss private banks, running for the doors but others will take a more long-term view."

One group of investors likely to be more jittery than most are the trustees of local authority pension funds, who have invested increasing amounts in the sector to reduce reliance on pure equities. Many will have ploughed considerable amounts of money in to escape volatility, only to see it increase.

Redemptions here could be sizeable, although many, like the South Yorkshire Pension Authority (SYPA), invest in single manager and fund-of-funds to spread risk. At the end of June, the SYPA had 2.15pc of its £3.8bn assets invested in alternative assets with an undisclosed portion in hedge funds.

John Hattersley, SYPA fund manager, says: "You can't tar all hedge funds with the same brush."

He stresses that as far as the SYPA is aware, it has not invested in CDOs or funds involved in risky financial engineering.

"I think it's true that we've seen a greater degree of correlation between strategies than we should have seen but equally if you'd been long-only you wouldn't have done very well either."

He is right. Hedge funds are not infallible, and never claimed to be. They are simply alternative ways of investing. If the events of the last few weeks have proven that - and helped more people to understand what they are investing in - so much the better.