As HFs Converge, More Suffer

Date: Tuesday, August 28, 2007
Author: Institutional Investor.com

Amid the finger pointing that quantitative hedge funds suffered losses because many ended up investing in the same things comes another revelation that explains why the subprime mortgage crisis had such a negative impact on the industry. It appears that even if they invest in totally different strategies, they usually use common approaches so that if one bet turns out wrong, a number of others will likewise feel the effects. According to The New York Times, the finding is supported by research released earlier this year by a troika of finance professors led by Nicole Boyson of Northeastern University, which stated that regardless of category, there was high probability that hedge funds of all stripes would experience significant losses when a bet goes bad. The factors causing this convergence – contagion, as it is called by the authors of the study – are many. Lawrence Tint, the retired chairman of Barclays Global Investors, told the Times, they include “the sheer number of hedge funds, the huge amount of assets invested in them, and the enormous amount of leverage that they employ,” as well as a fee structure that serves as an incentive for hedgies “to capture the last inch of competitive advantage.” Also helping spread the misery is the amount of illiquid assets they hold, which are problematic during a credit crunch. Finance Professor Andrew Lo of the Massachusetts Institute of Technology and chief scientific officer at AlphaSimplex Group, reports the Times, has expressed concern about the dangers illiquidity pose, as evidenced by what happened last year to Amaranth Advisors with its heavy bets in derivatives in natural gas future contracts. Lo, says the Times, notes that so-called “return persistence” – a measure of illiquid activity as evidence by returns regularly moving in the same direction – could have served as warning signal for things to come. Fortunately, as it turns out, Amaranth was pretty much alone in its derivatives bet, and as a result its losses were not widely felt. Next time, says Lo, hedge funds and their investors may not be so lucky.