Hedge Funds Have Another $200 Billion to go to Complete Their De-leveraging

Date: Tuesday, November 25, 2008
Author: William Patalon III, Money Morning.com

Hedge funds looking to slash their use of borrowed money may have to unload another $200 billion in assets to reach their objectives, a new study found, though a Money Morning expert believes the exit door could get pretty narrow should the holiday shopping season get off to a rocky start later this week.

Investors yanked $40 billion from the $1.5 trillion hedge fund industry in October, a month in which market losses slashed industry assets by an additional $115 billion, Hedge Fund Research Inc., reported. A new survey of hedge fund managers conducted by Sanford C. Bernstein & Co. LLC found that 63% said the sale of assets to cut leverage was at least half completed. Another 23% said the process was three-quarters complete.

To end this process – known in industry parlance as “de-leveraging” – “we estimate that roughly $200 billion will be additionally unwound,” Sanford C. Bernstein analyst Adam Parker wrote in a Nov. 21 report to clients.

Bernstein based its survey on interviews with managers of more than 65 hedge funds, with total assets of $100 billion. The interviews took place during the first two weeks of this month.

But retired hedge fund manager Shah Gilani, an editor for both Money Morning and the Trigger Event Strategist, says surveys as this one are often of limited use.

“Most hedge fund managers … are never going to tell you their positions,” Gilani says. “Never. It serves them no purpose whatsoever.”

Hedge funds are private investment funds that are open to a limited range of investors, largely because regulators allow them to pursue wider investment strategies and invest in a broader range of assets. In an effort to boost trading profits, they also use borrowed money, or leverage – a reality that more recently has forced them to dump assets to meet tighter lending requirements and to raise cash to fund client redemptions.

The amount of gross leverage used by hedge funds fell to 142% of assets from 175% in 2006 and 2007, Bloomberg News reported. Hedge funds have raised their cash holdings to an average of 31% of assets now, up substantially from the average of 7% in the previous two years, according to the survey.

This de-leveraging has caused losses in the U.S. stock-and-bond markets to snowball: The Standard & Poor’s Index 500 Index fell 38% this year through October, while hedge funds lost an average of 16%, according to data compiled by Hedge Fund Research Inc. At the end of last week, the S&P 500 was down 46% so far this year.

Some respondents said they expect this de-leveraging to continue as long as the Chicago Board Options Exchange Volatility Index, known as the VIX, remains elevated, Sanford C. Bernstein’s Parker said.

Of the hedge fund managers surveyed, 52% said the process of investor withdrawals is complete and that the transfers of money to clients will be done by the end of the first quarter, while 41% said they think half of redemptions are yet to come.

Clients putting in 30-day notices to withdraw their money for the end of December may be a catalyst for further de-leveraging, “a possible explanation for the recent steep sell-off,” Parker said.

But Gilani counsels investors to watch for retail sales reports from this Friday, the day after the Thanksgiving holiday – better-known as “Black Friday,” the unofficial start of the holiday shopping season. Analysts are projecting a poor shopping season, though the actual numerical estimates range from poor to downright dismal.

“If this traditional harbinger of the Christmas shopping season is, indeed, black, then the pummeling the markets will take from Monday morning’s sell-off will crystallize investors’ resolve to withdraw heavily in December,” Gilani says. “The potential implosion could be self-fulfilling as already-vulnerable retailers take it on the chin – with more than a few being forced seek bankruptcy protection.”

According to the survey, 42% of hedge funds use stock-market strategies, 25% use such “special-situation” events as mergers-and-acquisitions and spin-offs, 16% invest in emerging markets, 10% play fixed-income strategies, and 8% use a “macro” approach that invests in everything from commodities to stocks, the Bernstein survey found.

Not that the strategy really matters, Gilani said.

“It doesn’t matter where managers have been invested, the tide has taken all their holdings out to sea. The only players with sandcastles still standing in the Hamptons are those who have been massively short,” Gilani said. “Stocks … down; corporate bonds … down; oil …down; commodities…down; gold …down. [The markets have been so thoroughly pummeled that] it’s a bit like that old story about the fallen boxer, who’s down on the canvas and taking the 10-count. When his manager later asks him what happened, the boxer says: ‘You told me to wait ‘til the eight-count …[but] I looked up at the clock and it was only 7:30’.”

While the survey has focused on the important issue of de-leveraging, there’s another issue facing hedge funds that’s going to be a crucial issue for that industry to address in the not-too-distant future – source of funds, he said.

“Longer-term, what is even more insidious that no-one’s really talking about is that the source of funds that hedge funds use for their leverage, emanating from their banks and prime brokers, isn’t there. Period. No more Lehman (LEHMQ), no more Bear Stearns [now part of JP Morgan Chase & Co. (JPM)], and Morgan Stanley (MS) and Goldman Sachs Group Inc. (GS) are still de-leveraging. Do you think they’re going to give the money to failing hedge funds?”