A review of 2011: Hectic but manageable

Date: Wednesday, December 21, 2011
Author: Charles Gubert, COO Connect

2011 has been a turbulent year. Uprisings, urban riots and middle class anti-capitalist demonstrators have dominated the headlines. We have seen the demise of several crackpots (Kim Jong-Ill, Gaddafi, Bin Laden etc) and crack-heads (Amy Winehouse) - for that matter. High flyers have been brought down to earth (Dominic Strauss Kahn, Rupert Murdoch, Jon Corzine), while new talent has come to the fore (Pippa and Kate Middleton, Adele). The financial sector, particularly hedge funds, has not been spared from this pandemonium. COO Connect Editorial reviews the big issues that impacted hedge funds globally in 2011......

Market volatility

Hedge funds performed poorly in 2011 with the average manager suffering losses of 4.37%, according to Hedge Fund Research. Several big players failed to capitalise on the volatile markets. John Paulson, the hedge fund legend who made a fat wad of cash betting against sub-prime mortgages in 2008, saw his flagship fund decline by over 45% following a bullish stance on a US economic recovery and its investment in Sino-Forest Corp – an organisation, which faced accusations of overstating its timberland holdings earlier in the year. Sloane Robinson, Odey Asset Management and Lansdowne Partners all experienced double digit losses on their flagship funds too. The poor returns were exacerbated by intensifying fears of a double-dip recession. In Europe, the problem was not just confined to the perennial basket cases that are the PIIGS (Portugal, Ireland, Italy, Greece, Spain) but spread to the bigger economies such as France and Germany. Credit rating agencies put numerous European Union (EU) countries on alert for a negative downgrade while debate over the viability of the euro remains a hot topic. The US displayed disappointing growth figures while emerging economies including India and China failed to impress. Inflation and slow growth are issues of concern for these countries going into 2012. The average Asia ex-Japan hedge fund is down almost 16% indicating the region is not the golden chalice many people think it is. Natural disasters also hurt managers. Anyone with a bullish view on Japan was certainly thrown off course by March’s devastating tsunami. A Tunisian street vendor’s self-immolation set off a chain of events, which saw uprisings in Tunisia, Egypt, Libya, Syria, Yemen and Bahrain. Political risk re-entered hedge fund lexicon with a vengeance as many funds were caught off guard by these spontaneous revolutions. These interconnected macroeconomic events all impacted managers. Investors, according to JP Morgan, increasingly allocated to tail-risk hedge funds – some of whom have offered excellent returns during this turbulent period. One tail-risk fund – 36 South – had 93% year-to-date (YTD) returns in October 2011. Nevertheless, some brand name hedge funds navigated the choppy waters pretty well. Brevan Howard and Winton Capital Management enjoyed bumper pay-outs this year. While liquidations were high, there were more launches in the last quarter than at any time since 2007 indicating some renewed optimism. Whether or not these new funds survive 2012 remains to be seen.

Regulation, regulation, regulation

Dodd-Frank, the Alternative Investment Fund Managers Directive (AIFMD), FATCA, Ucits IV, OTC derivatives clearing reform, EMIR, MiFID II, Solvency II, Basel III etc. The list goes on. Managers all over the world are gearing up for registration with the US Securities and Exchange Commission (SEC) while the bigger players are fretting about the burdensome Form PF, a quarterly and very detailed reporting requirement. The SEC, after listening to industry participants, did make some concessions over Form PF. The asset threshold was increased from $1billion to $1.5 billion although this fell short of the $5 billion demanded by some experts. The submission deadline was pushed back from January 2012 until December 2012 although firms with $5 billion or more must hand in their Form PF by June 2012. The SEC also allowed managers to submit Form PF 60 days after each quarter - regulators realised the original 15 day timeline was unworkable. While these concessions are not ideal, they do make life easier for managers. The operational complexities and general intrusiveness of FATCA is also a worry – partly because nobody has much of a clue on what the finalised legislation will look like. Going after wealthy Americans abroad who are not paying tax is hardly going to be a vote loser so managers should not harbour hopes that FATCA will be repealed. Managers have been advised to perform gap analysis on what needs to be done to ensure compliance come January 2013. Mandatory OTC derivatives clearing is also going to ramp up operational costs for those hedge funds trading swaps. The industry will wonder whether exotic transactions, which are considered too risky for clearing houses and therefore must be traded bilaterally, will become prohibitively expensive for market participants. Hedge funds also asked whether a CCP could possibly fail. It’s happened before, it could happen again, especially if some CCPs start accepting lower grade collateral. EU directives came thick and fast raising concerns that managers might just dump the EU altogether. This seems unlikely in the near-term, particularly as other jurisdictions such as Switzerland and Singapore are unveiling their own equally tough rules on hedge funds. Nevertheless, if the EU gets its way with the Financial Transactions Tax – a levy on derivatives and securities transactions, managers and banks will surely depart en masse. Winton Capital’s David Harding came out in favour of a low transaction tax although he is in a minority. However, the likelihood of this bill ever seeing the light of day looks fairly remote given Britain’s opposition. Lawyers, administrators, compliance consultants and technology vendors will be popping some expensive corks this Christmas.

Counterparty risk

In 2008 and 2009, this was all the rage. As markets enjoyed a recovery, which lasted until the summer of 2011, the importance of counterparty risk somewhat rescinded. Countless investment banks had to reassure jittery customers that their exposure to sovereign debt was minimal much like they had to do with sub-prime back in 2008. Several banks including Credit Agricole, BNP Paribas, Goldman Sachs and Deutsche Bank have suffered credit downgrades over the last few weeks in what has been a torrid year for the eurozone. Hedge funds are certainly upping their operational due diligence on many counterparties. While not a prime broker, futures broker MF Global’s spectacularly disastrous bet on the eurozone turned sour with the firm declaring bankruptcy on October 31. The revelations that the firm did not segregate its own cash from that of its clients raised alarm bells about the internal management –or lack of - that may exist in smaller brokers. Whether smaller to mid-tier brokers will recover from the MF Global fall-out remains to be seen. With institutional investors demanding hedge funds use bulge-bracket brokers, mid and small-tier shops will either merge or shut down completely. Kewku Adoboli, a relatively junior UBS trader, shocked the world when it was revealed he had allegedly ramped up $2.3 billion in losses through unauthorised trading at the Swiss bank. UBS’s risk management was called into question with speculation the firm will get rid of its investment banking division to focus squarely on wealth management. Prime custody has grown in popularity over 2011 although hedge funds still view bankruptcy remote vehicles/special purpose vehicles with suspicion. Are these institutions really bankruptcy remote? Would the liquidation process be smooth given that it has been untested both practically and legally? Would an administrator risk a massive lawsuit by doling out assets or will a time-consuming court case ensue? Nobody knows. Let’s hope we don’t find out anytime soon. Counterparty risk is inevitably now back on the agenda for many hedge funds and institutional investors.

Corporate governance

Not the sexiest issue out there but one that is becoming very important. Hedge fund directors have not enjoyed the best press over the last year. The Weavering Capital case saw two hedge fund directors fined $111 million in Cayman for “default of duties” on the now defunct Weavering Capital hedge fund. The judgement raised serious questions over the standard of corporate governance in hedge funds. Both directors were conflicted and appeared to sign pretty much anything that was put in front of them. The issue re-entered the investor landscape following the Financial Times’ publication of the number of boards which directors from DMS Management, a professional services firm, sat on. According to the FT, several of its directors sit on hundreds of different boards. The case reignited investor demands for greater transparency from directors and caps on the number of boards they can sit on. Vocal investors including the Universities Superannuation Scheme (USS) have urged hedge funds to up the ante on corporate governance. The USS, along with several other major pension funds wrote to the Cayman regulators demanding an online database of hedge fund directors. The Alternative Investment Management Association (AIMA) released a guide advising managers to appoint independent directors. Cayman appears to have taken note and the jurisdiction is making changes to improve corporate governance. Whether these changes meet the standards of institutional investors with large wallets is up in the air.

Ucits hedge funds

Ucits hedge funds have seen a significant growth over the last few years – partly because countless investors view them as a safe investment – much like the Hong Kong investors who thought Lehman mini-bonds were risk free. Ucits hedge funds are not risk free. A lot of absolute return managers have shoehorned complex, structured products and synthetic exchange traded funds (ETFs) into these entities. Some of these illiquid assets are exactly that and offloading them if a bear market hits might prove impossible. Ucits, as a brand, is a fantastic creation but it is open to abuse. While Ucits hedge fund managers claim they are working within the rules of the Ucits framework, regulators could clamp down on what they view as unwelcome practices. There is widespread debate about splitting Ucits into “complex” and “non-complex” while the European Securities and Markets Authority (ESMA) has launched a consultation on the issue. If there is a Ucits blow-up, those managers that peddle Ucits hedge funds and the jurisdictions that support them, could suffer ramifications, particularly if widows and orphan investors find themselves getting burnt. This is not an unlikely scenario given the market volatility.

Short-selling restrictions

Optimists claim people learn from their mistakes. Cynics claim this is bollocks and they are right. Short-selling financial institutions was prohibited or restricted in several countries including Greece, France, Belgium, Italy, Portugal, Spain, Austria and South Korea despite similar bans having a detrimental impact on liquidity and stock prices in 2008. Numerous reports, including several by the European Commission, UK Financial Services Authority (FSA) and EDHEC, have stressed short-selling bans damage liquidity and exacerbate the woes of struggling stock. Christopher Cox, the man who had the misfortune of being chairman of the SEC during the financial crisis, described the 2008 short selling ban as one of the biggest mistakes of his career. Predictably, the ban had no effect and many of the financial institutions it was designed to protect suffered credit downgrades anyway. Not only that, the EU was hopelessly divided on the issue. French short-selling restrictions applied only to shares and convertibles, the Spanish ban extended to derivatives while the British didn’t even bother. These restrictions will probably remain in place well into 2012. Managers should brace themselves for tit-for-tat bans whenever markets look a bit stormy.

So what will the industry look like in 2012?

Commentators whose glasses are half full reckon hedge funds will regain their footing in the volatile markets and start generating alpha for their investors. Others take a more pessimistic view. COO Connect Editorial believes next year will be even more woeful than 2011. The eurozone is still divided and will probably get more so. It is unlikely it will break-up completely although it is very possible that one or more of the PIIGS might have to leave – a scenario which could have serious consequences. Pressure on Ireland’s low rate of corporate tax could spell the end of the funds’ industry in the jurisdiction although this could benefit London, Luxembourg and Switzerland. The US is unlikely to see much growth while emerging market powerhouses will experience slower growth and possible inflation. The Middle East remains an uncertain environment while Japan is still recovering from the tsunami. Regulation is going to hurt the industry – Dodd Frank, mandatory clearing of OTC derivatives and short-selling curbs will take their toll. Costs are going to go up, while investor demands will get more stringent. If hedge fund performance does not pick up, fees (and not unjustifiably so) will have to fall. Emerging managers will find it harder to break into the industry – even those spinning off from prop desks, liberated by the Volcker Rule, will struggle as operational costs become a drag on performance and the barrier to entry becomes higher. Counterparty risk will be high on agendas too still. If the eurozone fails, investment banks will join it. Whether or not prime brokers’ bankruptcy remote vehicles actually work will be monitored carefully. Smaller hedge funds, funds of funds, brokers and fund administrators will continue to shut or merge as the industry becomes increasingly cutthroat. Make no mistake, 2012 could be a very painful year for the industry.

May we wish all of our members and readers a happy and prosperous 2012!