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Hedge funds not out of mire yet as credit crunch continues to bite

Date: Wednesday, September 5, 2007
Author: thomsonimnews.com

LONDON (Thomson IM) - The hedge fund industry needs to brace itself for even more difficulties as the problems which initially affected credit managers spread across the spectrum of asset classes, according to Liz Chong, industry analyst from fund of hedge fund EIM.

Chong said: "Smaller firms with under 1 bln usd of assets under management are likely to be the most hurt." "To some degree hedge funds' returns will always be cyclical and influenced by events affecting the directionality of markets," Chong said.

For players outside the alternatives space, "the instant reaction is to blame the hedge fund industry for the panic", she added, "but they are not trading these securities on their own. Proprietary trading desks have taken on a great deal of risk, and some have reportedly lost substantial sums." Critical of the degree of risk aversion which has developed towards hedge funds, she argues that opacity surrounds losses and subprime exposures, which has stoked fear, "creating an environment where even the most absurd rumours circulate".

And the hedge fund industry is not helping itself, Chong said.

She concedes: "This is a byproduct of the ... industry's penchant for secrecy -- and it's to blame for the panic. Banks' or funds' trenchant denials of problems with exposure, only contradicted a week or two later, have only increased suspicion and distrust", she said. Over the last month, quant funds have come in for particularly scathing comments in terms of their operations and foresight.

Chong said: "The pain traders are feeling is magnified as quantitative funds are being forced to question the assumptions they used to construct their trading models which served them very well up until mid-July.

"Some of the flaws involve correlation", she added. She argues that a particular problem for quant funds is that they seem to have converged in their use of similar factors in their trading models, which has resulted in overcrowding.

She compares this with 2005 when convertible arbitrageurs were also left chasing a limited number of trading ideas, catching them out in May of that year, she said.

"This is a stern reminder that trading stems from ... academic theories being tested in markets transformed in the last 15 years by financial innovation and liberalisation", Chong said.

Looking forward, the EIM analyst said industry watchers should expect hedge funds to live up to their name by taking positions in a declining market to stem losses.

Some funds will inevitably stumble in these markets and be forced to shut but this is only part of a natural shake-out in an industry which has always known a high failure rate, "in line with the attrition rate for small businesses on both sides of the Atlantic", Chong argues. On a more positive note, Chong said, while there was concern recently about the impact of investor redemptions on hedge funds, there has not been much sign of this happening on a wide scale. And, "withdrawing cash now from most funds would mean redeeming your investment at a reduced value", Chong said. However, to counter this point she said that, in the case of strategies such as credit this is weighed against the prospect of further losses, which could be steeper. But, most would judge this unwise at this stage as healthy balance sheets and global economic strength still point to a recovery in equities, with an eventual comeback by credit markets, she argues.

In her latest final analysis of the current market turmoil, Chong said a global map of subprime and credit victims shows that risk has been widely dispersed, "from the Californian mortgage lender, Australian funds to German landesbanks." In one respect, she said, it shows that risk has been diversified well by securitisation in globalised capital markets, "but financial innovation by Wall Street and the City, fuelled by the excess liquidity awash in global markets, has now woven a web we are fighting to untangle".

As the industry grapples with the problem that it cannot price parts of the credit market, outflows are losing value purely on the back of sentiment.

One key lesson learnt from this mess, she said, "is that the nature of risk hasn't changed all that much".

By Ingrid Smith: +44 (0) 20 7422 4955; ingrid.smith@thomson.com. www.thomsonimnews.com ims/raj/bsd COPYRIGHT Copyright AFX News Limited 2007. All rights reserved.