Tight credit, falling stocks a lethal mix for hedge funds

Date: Wednesday, September 10, 2008
Author: Mark Noble, Advisor.ca

The global hedge fund industry has been ravaged by the U.S. subprime crisis and stands to lose more than $100 billion, according to predictions from the International Monetary Fund (IMF). In particular, long/short hedge fund strategies — the most common type of hedge fund strategy — face a difficult recovery.

Speaking at the World Alternative Investment Summit in Niagara Falls, Ontario, Mustafa Saiyid from the monetary and capital markets department of the IMF told attendees that tighter lending standards and a dour stock market is killing off hedge funds at an above-average pace.

Saiyid pointed out that the credit crisis, which originated in the U.S. subprime mortgage market, has wormed its way through the global markets and is now affecting myriad asset classes. The latest casualties appear to be prime mortgage-backed securities and corporate debt. As a result, Saiyid says the IMF expects the crisis won't completely work itself out of the system until around 2010.

In the meantime, hedge funds are suffering, Saiyid noted.

"The IMF anticipates about a $100 billion in losses for hedge funds [as a result of the global subprime crisis]. These hedge funds represent $100 billion in assets, so let's say they have a 40% recovery; we would be seeing about $60 billion in losses already," he says.

Most of these funds were invested in the structured debt or sovereign debt space, where the subprime crisis has been most intense. The failure in the debt and credit markets has forced prime brokers to substantially tighten their lending conditions, which has had a knock-on effect on most hedge fund strategies.

In the past, this type of environment would appear to be ideal for hedge fund investments, most notably long/short funds, which can use short-selling strategies to capitalize on the drop in stock prices. However, this isn't happening, because the increase in margin criteria from lenders makes shorting a very risky proposition. For example, even on investment grade bonds, the margin requirements for borrowing have increased four-fold since April 2007, Saiyid pointed out, from between 0% and 3%, to 8% to 12%.

"The leverage used by the hedge funds is not out of the ordinary, nowhere near the levels that were seen with Long-Term Capital Management in the 1990s," Saiyid says. "[The funds that have failed] are having only a small change in asset value, but then redemptions start coming in and then they are trying to scramble to pay those margin calls."

Saiyid outlined that, in today's market environment, a leveraged fund that posts a 5% loss on a 15% margin could quickly find itself struggling to stay afloat.

"Your asset value drops to 95% and you're going to suffer a margin call, because your margin has dropped to 10.5%. In order to make up that margin and bring it back up to 15%, you basically reduce the amount of borrowing you have and that brings your asset value down to 66%," he says.

At that point it's likely the margin required to borrow will increase as well.

"What happens if your margins have increased from 15% to 25%? You'll see the asset value of the fund drop to 40% from 66%," he says. "Let's assume investors get the quarterly statement and they are looking at a hedge fund that has dropped from 100 to 40 — what are they going to do? Most likely pull their money out if they can."

At a panel discussion later in the conference, Gregg Berman, from RiskMetrics Group, said hedge funds must look to develop means of measuring funding risk. He said hedge funds that employ multiple strategies, for example a fund that uses fixed-income and long/short strategies, has to recognize the two units are interdependent or "coupled," even though they are investing in different sectors.

"What people didn't understand is the coupling effect the subprime crisis has had on strategies that are otherwise economically unrelated. Long/short funds lost a lot of money in 2007," he says. "It's a phenomenon that's only about 18 months old. People still have not got their head around it."

Berman says if the fixed-income unit of a multi-strategy fund has to come up with money to cover the margin call for its prime broker to cover, it will affect other investment units within the fund. The fixed-income portion of a multi-strategy fund is more likely to face illiquid positions than an equity portion, meaning the fund will have to sell the equities to cover a margin call, even if it had a long-term buy-and-hold position on those stocks.

"You can't sell those illiquid positions, so you go to the liquid positions, which tend to be found in the long-short strategy. When you sell out of one of those strategies, it's the equivalent of exiting the market — you put downward pressure on the market," he says. "Now you have the long/short manager who had nothing to do with the credit crisis, but his fund is losing 3% to 4% a day because of the downward pressure they [themselves] have put on the stocks they own."

In a bid to keep investors from jumping ship, hedge funds are doing something virtually unheard of in the past — cutting fees. Saiyid pointed out that data from Morgan Stanley shows that, in a bid to keep investors, hedge funds have cut their fees on average from 2% to 1.5% over the last year.

Even apart from the fee-drop, he says anecdotally he's seeing a lot of institutional investors moving into the space.

"I was at a conference a couple of months ago and I ran into someone who works with one of the large university endowments on the west coast and they are actually doubling their hedge fund allocation from 20% to 40%," he says. "They are interested in hedge funds for the long term and they see them as the way of the future instead of the traditional benchmark-hugging investment firms."

Filed by Mark Noble, Advisor.ca, Mark.Noble@advisor.rogers.com