Doomsday Clock for Hedge Funds Is Ticking

Date: Tuesday, September 25, 2007
Author: Zubin Jelveh, Portfolio.com

Without access to any proprietary data, Amir E. Khandani and Andrew W. Lo, two financial engineers at M.I.T. (though Lo does run his own hedge fund), set out to reconstruct the blood bath brought upon many quant funds that traded in stocks in August. During that week, several long-short equity hedge funds experienced unprecedented losses. As David Viniar, CFO of Goldman Sachs, said in what I'd nominate as the quote of the year, "We were seeing things that were 25-standard deviation moves, several days in a row."

Using what they call a "simplistic" long-short strategy, Khandani and Lo simulated the performance swings of the week of August 6th. They found that the initial quant fund losses were probably attributed to the closing -- or unwinding -- of one or more equity market-neutral portfolios. (This unwinding was likely a result of either a multi-strategy fund or prop-desk responding to margin calls from a crumbling credit portfolio, a calculated move to reduce exposure given the credit climate, or a change in business plan.)

Khandani and Lo's results suggest that hedge funds may have grown more dangerous since the demise of Long-Term Capital Management in 1998:

The specific mechanism that caused [the LTCM] losses--widening credit spreads that generated margin calls, which caused the unwinding of illiquid portfolios, causing further losses and additional margin calls, leading ultimately to a fund's collapse--is virtually identical to the sub-prime mortgage problems that affected Bear Stearns and other credit-sensitive hedge funds in 2007.

The difference is that in 1998, long-short equity hedge funds were not markedly affected by the market turmoil outside of their sector. This means that thanks to increased network effects, the chance for a disruption in one part of the financial matrix affecting a seemingly unrelated part has grown in recent years.

And that means that some calls for hedge fund regulation may be misguided, write Khandani and Lo. Current arguments for regulation are centered on protecting investors, but the current regulatory mechanisms won't prevent a much more dire consequence of out of whack hedge funds: systemic risk.

Khandani and Lo argue that the Rube Goldberg-like machinations of August -- the sub-prime mess spreading into equity-only hedge funds -- reveal how much more integrated the world financial system has grown since LTCM and that many long-short equity hedge funds are using basically the same strategies, helping to create a "hedge fund beta."

Also worrisome is that long-short equity hedge fund returns are increasingly correlated, despite the rapid growth in the sector. Usually when something becomes more liquid, correlations and predictably of returns diminishes as more and more investors take advantage of arbitrage opportunities. The fact that correlations for these types of hedge funds are increasing suggests that there is a "significant decline in the liquidity of this sector." (Though liquidity is still much higher than in most other hedge fund strategies.)

Khandani and Lo also argue that the line between heavily regulated banks and hedge funds is blurring:

Hedge funds are becoming more like banks, and the reason that the banking industry is so highly regulated is precisely because of the enormous social externalities banks generate when they succeed, and when they fail. Unlike banks, hedge funds can decide to withdraw liquidity at a moment's notice, and while this may be acceptable if it occurs rarely and randomly, a coordinated withdrawal of liquidity among an entire sector of hedge funds could have disastrous consequences for the viability of the financial system if it occurs at the wrong time and in the wrong sector.

So, how to protect against risks to the world markets?

Introducing the Capital Markets Safety Board. Modeled after the National Transportation Safety Board, this body of forensic accountants, lawyers and financial engineers would monitor the world's capital markets for signs of increased systemic risk.

But the writers say that while all of this may sound like an indictment of hedge fund strategies, it's anything but. Indeed, many hedge funds survived August unscathed.

Still, we should be weary:

"If we were to develop a Doomsday Clock for the hedge-fund industry's impact on the global financial system, calibrated to 5 minutes to midnight in August 1998, and 15 minutes to midnight in January 1999, then our current outlook for the state of systemic risk in the hedge-fund industry is about 11:51pm. For the moment, markets seem to have stabilized, but the clock is ticking... "