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Hedge Funds `Frozen in Headlights' Cut Trading

Date: Friday, July 9, 2010
Author: Saijel Kishan and Katherine Burton, Bloomberg

Hedge-fund managers, Wall Street’s best compensated and supposedly smartest investors, are dazed and confused.

Reeling from the worst second-quarter performance in a decade, hedge funds have scaled back trading as they struggle to figure out where markets are headed amid sometimes vicious crosscurrents in stock, commodities and other markets, according to brokers and managers.

“There’s a degree of being frozen in the headlights, of not knowing what sectors to emphasize, of what securities to emphasize,” said Tim Ghriskey, chief investment officer of Solaris Asset Management LLC, a firm in Bedford Hills, New York, with $2 billion in hedge funds and conventional stock funds.

Hedge-fund managers, who oversee $1.67 trillion in assets, are reluctant to put money to work as they are buffeted by a wide range of often conflicting political and economic forces, from fiscal policy in Europe and the U.S., to what regulations will be imposed on the financial-services and energy industries, to the growth prospects in China. In turn, smaller and fewer trades may make it harder for funds to rebound from losses incurred since May, when the industry suffered its worst decline in 18 months.

“For many people, it’s a frustrating market given the high volatility and low volumes,” said Aaron Garvey, portfolio manager at MKP Capital Management LLC, a New York-based hedge fund overseeing $3.5 billion. “We are seeing strong opposing forces in the markets, which makes generating strong convictions difficult for the medium- and long-term.”

Holding Cash

Prime brokers such as Credit Suisse Group AG and JPMorgan Chase & Co. that service hedge funds report that managers are borrowing less money and are sitting on more cash. Credit Suisse’s hedge-fund clients held 24 percent of their assets in cash in June, compared with 19 percent three months earlier, according to the Zurich-based bank’s prime brokerage unit.

“People are in cash for the most part and nobody’s really taking out any big bets,” said Blaze Tankersley, chief market strategist at Bay Crest Partners LLC, a brokerage firm in New York. “Nobody wants to take risk in either direction. It’s a weird time in the market.”

U.S. stock market trading last month had its steepest June decline in at least 13 years. Daily trading volume for the Standard & Poor’s 500 Index of the largest U.S. companies averaged 1.09 billion shares in June, 20 percent less than in May. The 15 percent decrease last year was the second-biggest slump between May and June in Bloomberg data going back to 1997.

No ‘Summer Lull’

Hedge funds account for 20 percent of the equities volume in the U.S., according to Tabb Group LLC, a New York-based adviser to financial-service companies.

Trading of options on stocks, indexes and exchange-traded funds on the eight U.S. exchanges also fell in June, declining 2 percent from last year to 309 million contracts for the month, according to the Chicago-based Options Clearing Corp. Options are contracts that give the right to buy or sell assets at a set price by a specific date.

“This is much more than a summer lull,” said Sam Hocking, global head of prime brokerage sales at BNP Paribas SA. “Given the uncertainty out there, many hedge funds have felt it wise to pull back and take risk off the table.”

Credit Suisse says its hedge-fund clients have cut their borrowing, or gross leverage, to about 2.5 times assets in June compared with 2.8 times assets in March.

Stock Market Decline

“We’re trying to reduce risk by downsizing of our trades,” said Max Trautman, a former Goldman Sachs Group Inc. proprietary trader and co-founder of Stoneworks Asset Management LLP, a $460 million macro hedge fund based in London. “It’s not that we have stopped taking views but we’re just putting less risk in them.”

Global stocks posted the biggest losses in the second quarter since the bull market began last year, as the sovereign- debt crisis in Greece threatened to spread to other European countries.

Chinese government restrictions on lending and real estate, intended to prevent the world’s third-largest economy from overheating, added to concerns global growth may slow. In the U.S., slowing growth in manufacturing, an unexpected jump in jobless claims and a slump in home sales have fueled concern the economic recovery is faltering.

Biggs Sells

Barton Biggs, whose purchase of stocks in March 2009 gave Traxis Partners LLC a 38 percent gain last year, said last week he sold about half his stock investments because of concern governments around the world are curtailing stimulus measures too soon.

“I’m not wildly bearish, but I don’t want to have a lot of risk at this point,” Biggs, who manages $1.4 billion, said in a telephone interview. “I’m not putting my money into anything. I’m raising cash.”

Hedge-fund managers say they’re also worried about the impact of financial reform being introduced as a result of the Wall Street meltdown, and energy regulation following the BP Plc oil spill in the Gulf of Mexico, the largest in U.S. history.

Among managers sticking to convictions is John Paulson, who is betting on a U.S. economic recovery after making $15 billion with a wager against home mortgages during the financial crisis. Paulson lost 6.9 percent in June in his Advantage Plus hedge fund and 4.4 percent in his Advantage fund, according to two investors briefed on the returns.

Paulson’s Convictions

The funds were positioned to profit from a jump in stocks including financial-services companies, said the clients, who asked not to be named because the fund is private.

Paulson, who runs the $33 billion New York-based Paulson & Co., hasn’t changed his bullish views after the stock market’s decline and last week’s data showing weaker-than-expected private-sector employment in June, according to the investors. Almost two-thirds of the firm’s assets are in his Advantage funds, which invest in corporate events such as bankruptcies and mergers.

Paulson, 54, has told clients he expects inflation to increase over the next three to five years, which is why he has also been buying gold and mining shares, including AngloGold Ashanti Ltd. and Kinross Gold Corp. Gold has risen about 10 percent this year. Paulson’s Gold Fund climbed 7.3 percent in June and 13 percent for the year, the investors said.

Armel Leslie, a spokesman for the fund firm, declined to comment.

‘High Correlation’

Hedge funds declined 0.94 percent in June and 2.79 percent in the three months ended June, the worst second-quarter performance since 2000 when the industry lost 3.42 percent, according to Hedge Fund Research’s HFRX Global Hedge Fund Index. The index dropped 1.2 percent in the first half of this year.

There’s “a high degree of correlation among stocks, so it’s not the best environment for stock picking, or sector allocation,” said Solaris’s Ghriskey. “Investors are not moving money around between sectors, nor are they aggressively moving between fixed income and equities.”

Trading of U.S. corporate bonds fell 4 percent in June from the previous month, the first decline between May and June since 2006, according to data compiled by the Financial Industry Regulatory Authority.

Some hedge-fund investors prefer that managers don’t place large bets to offset losses this year.

‘Capital Preservation’

“It’s all about capital preservation at the moment,” said Amit Shabi, a Paris-based partner at Bernheim Dreyfus & Co., which farms out client money to hedge funds. “The losses of 2008 are still fresh in investor’s memories and so managers should be cautious.”

Hedge funds lost an average 19 percent in 2008, the worst returns since Chicago-based Hedge Fund Research started tracking data in 1990. While the industry rebounded 20 percent last year, almost half of the 2,000 funds that make up the HFRI Fund Weighted Composite Index ended the first quarter of 2010 below their high-water mark, or peak net asset value, meaning they can’t charge investors performance fees.

Some hedge-fund managers say the outlook for the U.S. economy will become clearer after companies report second- quarter earnings in the latter half of July, and executives talk about their outlook for the rest of the year. Investors are also looking to results from European banks’ stress tests, due out later this month, and data on U.S. economic growth scheduled to come out on July 30.

‘Cogs in the Wheel’

Companies in the S&P 500 Index increased profit by 34 percent during the second quarter, according to the average analyst estimates collected by Bloomberg. The U.S. economy will grow at a 3.2 percent annual rate this quarter, down from a prior estimate of 4 percent, JPMorgan said in a July 1 note to clients.

Sylvan Chackman, global co-head of prime brokerage at Bank of America Corp. in New York, said he expects hedge funds to increase trading this quarter.

“They need to put their capital to work to generate returns,” he said.

John Trammell, chief executive officer of New York-based Cadogan Management LLC, said it might take until the end of the year or the start of 2011 for managers to get clarity about the direction of markets.

“There are so many cogs in the wheel,” said Trammel, whose firm invests about $2.7 billion of client money in hedge funds. “We need more details on the fiscal positions in Europe and then have to wait to see whether the policies will work or not.”

To contact the reporters on this story: Saijel Kishan in New York at skishan@bloomberg.net; Katherine Burton in New York at kburton@bloomberg.net