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Can hedge funds live to fight another day?

Date: Thursday, January 15, 2009
Author: David Craig, Spectator.co.uk

Losses are mounting and clients are clamouring for their cash in the aftermath of the Madoff scandal. But veteran professional investor David Craig has not given up hope.

Hedge Fund Land seems to be in disarray. Investment losses keep mounting up. It would not come as a surprise to hear that fully 70 per cent of these often complex and sophisticated offshore investment vehicles have percentage losses running into double figures over the last year, with a large number down by over 25 per cent. This all seems to point conclusively to the fact that the majority of practitioners are unable to cope with market conditions and have failed to remember Investment Rule 1.01 for confronting losses: ‘Get out, stop losing and live to fight another day.’

The fact that most funds are losing should not be a cause for complete surprise, however. This brutal market has been nigh on impossible to stand up to. It set out to administer death by a thousand cuts, and has certainly taken a toll. Yet is that really much different to the sorts of frightening results suffered in past crashes and declines? There are those, myself included, who have been through a few of those episodes and believe that this time it is different — very different indeed. There are new risks to face, as well as new lessons to be learned.

Let us look back at previous episodes, starting with the Crash of ’87. When the stock market tumbled in October 1987 the decline experienced over the course of a few days by the Standard & Poor’s index of leading US stocks amounted to a massive 25 per cent. The sense abroad on Black Monday and the preceding Friday was that this was a deadly situation. The hedge fund for which I was responsible was cast adrift and severely tossed around. We had only one thought at the time — to get out at almost any cost. But that was not easy as we encountered massive swings in the value of the complex (by the standards of the time) arbitrage portfolio we had taken years carefully assembling.

We had borrowings against our portfolio and we were extended across geographic regions, trading between markets that were anything but fungible. In one typical case (out of a dozen similar situations), with credit extended by Mr Willman, the manager of Barclays’ Stock Exchange branch — a true pioneer in the business of margin lending — we were exposed to a long equity position in Elders IXL, an acquisitive Australian conglomerate. Our position was covered on the downside by an outsized, custom-written ‘put option’ (a contract giving us the right to sell at a pre-set price) that would give us a profit as Elders share price fell. The counterparty was a Monaco-based private investor group, made up of very wealthy Australians who had made a billion backing Elders. They believed Elders’ share price was going to carry on upwards to the clouds. To them, our suggestion that we pay for the right to sell shares to them at a pre-set price, some way below market, looked like free money.

A more simple example was a geared holding in a London-traded Asian investment trust we had bought at a big discount; part of this holding was hedged by going short of Hang Seng stock index futures in Hong Kong. As the crash ballooned out, the value of our long positions cratered and our highly profitable ‘shorts’ proceeded to take on quite unexpected characteristics.

First, just a few days into the rout, the Hong Kong futures market was closed down until further notice, leaving margin payments unsettled. Then the Monaco telephone number went unanswered when we called to collect our substantial profit from the Elders option.

We should have been ahead on these trades, but we were in fact stuffed — desperately in need of cash to meet any margin call that Mr Willman might impose. Neither of these two counterparties was likely to make the timely payment expected of them into our dwindling bank account. So we found ourselves learning at first hand the true meaning of a number of risk definitions that had just come into our lives.

We learned something about ‘counter-party risk’, which you suffer if the people you trade with fail to meet their obligations. We learned about ‘basis risk’: the likely extent to which two related securities can deviate in price from one another. We had first-hand experience of ‘correlation risk’, where seemingly quite independent positions behaved in the same way, thereby destroying the notion that we had real diversification across our portfolio. And we learned quickly to avoid becoming wedded to ‘stranded value’: that is, not ending up stuck with holdings that we thought were cheap, but which turned out to be friendless no-hopers.

Most important of all, we learned how dangerous leverage (using borrowed money to enhance investment returns) can be. We saw what it was like to encounter movements in which leverage amplified losses to the power of x — utterly life-threatening.

In those days, whatever was happening to hedge funds went pretty well unnoticed in the context of the greater scheme. There were only a small group of players in the business (no more than a dozen or so London-based funds) and pretty well all of us survived. We probably even helped counter some of the extreme movements in mainstream markets by selling as others tried to average in, and by buying when others capitulated. Somehow we knew we were doing the right things and we sensed that normality would quickly return — because, unlike today, we believed that the system was robust. Leverage was not widespread. Banks were solvent. There was no major hedge fund fraud. In an unregulated market that offered such high returns, any untoward method of losing money was something we simply had to be philosophical about and take on the chin.

Our next formative experience was the 1989 Tokyo bubble. A year before its peak, Julian Robertson, who ran the Tiger Fund, visited our office in London and told us he had opened a big short position in Japanese equities which he thought were at an extreme of overvaluation. He believed the massive credit bubble in Japan was ready to burst and that every bank in Japan was a candidate for a ‘short’. To some extent we were singing from the same songsheet, because all this had been prophesied by one of our advisers, Brian Reading, a brilliant strategist who had that year written a book entitled Japan — the Coming Collapse. Brian’s timing was spot on and the market duly crashed in 1989; those who were short in Tokyo, or who held put options, made out handsomely. Julian made 70 per cent for his investors that year and was very definitely a man of the moment.

We saw at first hand that this was no ordinary market correction. It was a deep-rooted financial crisis in which the entire Japanese banking system was technically rendered bust. Real estate values, which had reached astronomical highs, collapsed; so did overpriced equities. Almost 20 years later, Japanese markets have yet to come anywhere close to a period of sustained recovery to match former levels. Adding to the challenge, the whole approach to trading in Japanese stocks has changed. Whatever used to make prices rise and fall, those rules no longer seem to apply in today’s market. Investing in Japan has become just ‘too hard’: there are very few hedge funds operating successfully in those markets today. This sets one thinking about what could happen in our own markets over the coming decade or two.

We move forward to 1998, when one of the most illustrious US-based ‘relative value’ hedge funds, Long Term Capital Management, was completely annihilated. The hedge fund universe was traumatised by the temporary destabilisation of one of its most important components, the fixed-income arbitrage market — in which skinny ‘spreads’, or profit margins, achieved by going long of one bond and short of another, could be greatly amplified by leverage. For a while, stock markets experienced severe collateral damage; ‘systemic’ risk seemed to be rising to dangerous levels.

By this time my own firm had all its investments run by other professional managers, so we saw from the sidelines how they learned lessons from experiences similar to those we had found ourselves dealing with back in 1987. We also saw, somewhat remarkably, how a hedge fund run by Bernie Madoff, that had been recommended to us many times over the years, sailed through this turbulent time and made a profit, to the rapturous appreciation of his loyal followers. We were impressed — but we just could not figure out how he managed to achieve his publicised result. As much as we tried to, we could not get there, so we never invested. Luck was clearly on our side.

The crisis of 1998 was very much a hedge fund matter. Newspaper headlines declared the demise of billionaire hedge fund managers, and indeed there were those who fell by the wayside and were forgotten. But most survived by doing a first-class job — first by retreating to the sidelines and eventually by timing a profitable return to the offensive.

Our portfolio managed to climb back to breakeven in 1998 and then went on to make over 40 per cent in 1999 by repositioning into areas that we felt offered juicy spreads. We garnered high returns from funds specialising in convertible bond arbitrage, distressed and high-yield debt, merger arbitrage and ‘event-driven’ equity opportunities — all offered spoils for the survivors.

And so to the events that have brought us to today’s sighting of Armageddon. Positive returns by many hedge funds in the equity bear market of 2000 to 2003, made by shorting technology stocks that were set for a fall, attracted a whole new following to the world of hedge fund wizardry. A new-found respectability ensured that everyone who was anyone in the monied world was drawn into investing in this now credible asset class. But these new investors were not well educated in the risks involved.

Fast forward to the period we now find ourselves in — where new and greater lessons are being learned, and where everyone, veterans included, has been caught out. The negative effects of the wider economic climate continue to confound analysts who have hung on to their ‘stranded value’ convictions — a fatal mistake for so many practitioners who forget the importance of Rule 1.01. Their losses look permanent and irrecoverable, as opposed to the temporary declines of previous downturns, when value opportunities were to be seized upon.

Pressure to unwind losing trades remains so big that there may be further waves of capitulation by sellers still to come — except that frequently managers cannot sell because liquidity is not there to facilitate an exit. This constitutes a really significant threat: as the whole liquidity chain breaks down, the system is seizing up.

Many securities have now become stranded, forcing funds with illiquid holdings to renege on their advertised redemption terms — something that funds both new and old, big and small, famous and obscure, have all succumbed to. This new problem for hedge fund investors — being denied the liquidity that allows them to withdraw when they wish — causes extraordinary anxiety. It heightens the perception that investors drawn into these funds after making losses in the last equity bear market are all now stuck in portfolios of hedge funds whose managers have lost the plot. The financial wizards have been discovered as having failed to weave any magic to get them through their own complex investment maze. These Merlins have lost their credibility. No wonder investors are giving up on hedge funds in their droves and seeking a way round the gates that keep them locked in.

One exit is to sell in the growing over-the-counter private secondary market dominated by agents such as Hedgebay, a Bahamas-based intermediary, and by banks in Switzerland. Here you might find liquidity for the better-known hedge funds, but at a price. A 10 per cent discount is a good outcome; 20 per cent is more commonplace. Many hapless investors appear to be willing to suffer that cost in order to gain release from their state of anxiety, and to stem the seemingly continuous decline in the value of their holdings.

The final blow to the industry’s credibility and reputation came with the complete failure by so many of the gatekeepers, otherwise known as ‘fund of funds managers’, to resist the tantalising returns proffered by Bernie Madoff, who now stands accused of building a $50 billion Ponzi scheme over 15 years by promising something utterly desirable in the form of stable and dependable average high-single-digit returns. Had his results been twice as high he would never have got the support of L’Oréal owner Liliane Bettencourt, the film director Stephen Spielberg, the heiress Alicia Koplowitz, the British tycoon Lord Jacobs of Belgravia and other wealthy individuals and families. The rich do not usually expect to get a whole lot richer, but they work hard to hang on to what they have. Madoff appeared to deliver on that goal year in, year out.

The average hedge fund investor has come to realise that he or she has been cast completely adrift, with a lesson learnt for a lifetime: investing in the promise of financial alchemy is an extremely dangerous pastime. But as for me, I believe that to walk away from hedge funds will almost certainly be bad for my long-term financial health, because it is here that many of the most talented investors on the planet are still to be found. It is no different to walking away from equities: something one will sooner or later come to regret. So I have decided to keep the faith. After a short period on the sidelines in adherence to Rule 1.01, I will once again forage in these lush but now deserted pastures with my eyes open for that very, very special talent who can deliver extraordinary results — and for the occasional fraudster along the way.