The curious incident of hedge funds during the financial crisis

Date: Friday, July 24, 2009
Author: Abnormal Returns

“Is there any point to which you would wish to draw my attention?”

“To the curious incident of the dog in the night-time.”

“The dog did nothing in the night-time.”

“That was the curious incident,”

from “Silver Blaze” a Sherlock Holmes story by Sir Author Conan Doyle.

The curious incident of which we speak is hedge funds during the economic crisis.

Prior to the crisis there were widespread fears that hedge funds would cause a global market hiccup.  According to analysts they were too big, traded too much and worst of all they made way too much money.   One need only look the list of the top paid money management execs to see that hedge fund managers made ungodly amounts of money.

There were fears that the many crowded hedge fund trades would lead to a LTCM-like meltdown. Flash forward two years to post-economic meltdown 2009.  Who would have thought that on the back side of an financial crisis that the hedge fund business model would emerge, while badly bruised, largely intact?

While the state of hedge funds is still a bit shaky with redemptions continuing to dog hedge funds.  However the value of assets under management increased in the second quarter of 2009.  This was due in large part to positive investment returns, but absent another leg down in the markets it seems that hedge funds may have seen the storm pass.

In hindsight it wasn’t unregulated hedge funds that blew up the global economic system, it was the banks.  Bank risk management systems failed.  Banks shoved assets into off-balance sheet entities that came back to haunt them.  It was the banks around the world were forced to seek bailouts from their respective governments.

Nor were hedge funds the main culprit behind the problems facing elite university endowments.  (See “Rich Harvard, Poor Harvard” by Nina Munk at VanityFair.com)  These endowments were viewed as the best investors around.  Amidst the crisis many endowments faced a cash crunch.  This crunch came from the unfunded commitments to private equity funds and the severe drop in cash returned by private equity funds to investors.  Hedge funds are viewed as a readier source of cash and have therefore seen redemptions.

It is not like the last two years have been easy for hedge funds.  A number of hedge funds blew up, including a number of high profile funds.  Many of the funds that did not close incurred investor redemptions that forced them to invoke various gating schemes to slow the outflow of capital.  And given their poor returns many hedge funds now sit way below their high water markets unable to draw incentive feeds.

On a smaller scale one could also look to the more regulated sector of the money management business for comfort.  Again, returns on nearly every asset class in 2008 were awful and are reflected in poor hedge fund performance.  This is prompting a reduction in the number of funds, but this process goes on absent much drama to the end user.

It is ironic that the purportedly least risky sector of the investment management business, money market mutual funds, were forced to seek government aid.  This was due in part to the implication that the funds would not break the buck, and if they did the management company would bail them out.  Come late 2008 it was clear that the managers could not make good on that implied promise.  Only the government could stanch the flow out of these funds that are viewed like regulated utilities.

The hedge fund industry is made up a variety of investment strategies and levels of risk.  The term hedge fund is of course a misnomer.  Hedge funds, or private investment funds, are better described as risky funds.  Most investors recognize when they put their capital into the fund that their capital is at-risk.  Some strategies are designed to be lower risk, but there exists the potential for losses.  However absent fraud, investors will realize returns dependent on the markets and the skill of the managers.

There has been a great deal of talk recently about Goldman Sachs and the extraordinary profit performance the firm is showing just a few months removed having to be bailed out the government.  Goldman has been called just a big (levered) hedge fund.  The compensation practices certainly can compare to that of hedge funds.

However we need to view Goldman’s risk taking in a new light.  As a bank holding company viewed as too-big-to-fail Goldman should not be viewed as a hedge fund, or risky fund.  While Goldman may now feel comfortable (and overconfident) to do that, putting the US taxpayer on the hook for that sort of risk taking should be discouraged.

There are now clear lines of distinction between the banks and their explicit and implicit federal guarantees and hedge funds.  During the crisis, hedge funds have closed (and opened) on a routine basis.  The number of closings has accelerated during the crisis, but the process is with some exceptions, unremarkable.  However the failure of a large bank, like Goldman, would bring about a whole host of additional risks to the system.

That’s it may make sense to “de-risk” Goldman and other banks so that they do not pose a future risk to the system.  If management (and shareholders) choose to stay in the riskier lines of business they can spin these operations off, removing these risky funds from the purview of the bank structure.

The hedge fund industry has seemingly escaped much in the way of additional regulation in the administration’s proposed legislation.  Under the Obama plan hedge funds would be required to register with the SEC as investment advisers and provide additional position information, but beyond that they would operate as before.

Although hedge funds have escaped the worst of the financial crisis, that is not to say that hedge funds don’t have their own problems to deal with.  Once investor redemptions are taken care of there is a whole host of outstanding issues.  The first of which is the demise of the fund of fund.  That structure is now being shunned by investors due to poor performance and the layering of fees on top of fees.

Speaking of fees, that may be the one area most in need of change.  The standard fee structure of 2&20 seems generous in light of an interest rate environment of nearly 0% short-term yields and a 4% ten-year bond.  In addition, incentive fees probably need to be calculated against some sort of benchmark that isn’t 0%.  See this story by Cyrus Sanati at DealBook about a start-up hedge fund that is taking a new approach with lower fees and enhanced liquidity.

Hedge funds continue to close despite the seeming end of the financial crisis.  That is in part because many funds are so far below their high water marks that they little chance of earning performance fees any time soon.  Many of those managers re-open their funds to escape this trap.  That is why people like high profile managers like John Meriwether and T. Boone Pickens continue to operate.   While perplexing this an investor problem more than a hedge fund structure problem.

When you invest in a hedge fund you should recognize that this is a risky proposition.  The hedge fund model, while bruised and in need of a bit of an overhaul, came through the crisis largely intact.  The same cannot be said for large swaths of the rest of the financial services industry.  Perhaps it is time we applied the lessons of hedge funds to the rest of the industry by clearly delineating those institutions that should be free of risk to the taxpayer and riskier firms like hedge funds that are clearly known to be at-risk investments.