A Big Broom Comes A-Sweeping

Where does the credit crisis leave hedge funds now?

Originally published in the October 2008 issue

At the recent Guernsey Fund Forum in London, a band of dour offshore bankers were continuing to man the Fortis stall, in the knowledge that they now technically worked for the Dutch government. They were eagerly checking their Blackberries for further news of who their bank’s ultimate parent might be (a bid by BNP Paribas having seemingly been derailed over the previous weekend); there was also no guarantee Fortis’ offshore fund administration and corporate trust business in Guernsey would remain with the rest of the group, but could be sold off as part of an eventual break-up. “There is a big broom sweeping through this market, and it is sweeping up a lot of people,” one of them dolefully told The Hedge Fund Journal.

There are really three tales to be told here, as far as hedge funds and their investors are concerned. One relates to the performance of hedge funds; one involves the risks hedge funds are now facing in terms of their counterparties, including their prime brokers and other service providers like the ill-fated Fortis; and one stems from the other external factors managers will need to take into consideration next year, possibly sooner, of a political and regulatory nature.


For investors, of course, the most pressing concern has to be the performance of hedge funds. As anticipated by this journal, a large slice of the long/short equity fraternity has proved to be more reliant on their long positions than their short game. This has led hundreds of hedge funds to follow the major stock-market indices into the abyss, much to the displeasure of investors. According to Hedge Fund Research data through to 7 October, Equity Hedge was down 15.33% YTD, and has not been in the black on a monthly basis since May, when it recorded a 2.38% return. Fixed Income Convertible Arbitrage is also being hammered, down 20.44%. Most other strategies have also lost money, with the exception of Short Bias (+15.14%), Macro (+3.32%), Macro – Systematic Diversified (+9.47%), and Asset-Backed Fixed Income (+3.08%).

But some in the convertible arbitrage space see this as a buying opportunity. Calamos Investments, one of the pioneering managers in convertible arbitrage, said it was re-opening all share classes of its Calamos Convertible Fund, a fund which has been closed since 2003. “We’ve had many requests over the years to re-open the Convertible Fund,and our response has always been ‘not until we identify a significant opportunity that may be advantageous for both new and existing investors,’” says John Calamos, the co-CIO of the Illinois-based firm. “Well, we think we’ve found one…Existing high quality issues appear under-valued, and the overall risk/return profile appears quite attractive for investors who can look beyond the current crisis.”

We’re not going to dwell on emerging markets too much, because if you thought convertible arbitrage was a nightmare, Asia ex-Japan and Russia/Eastern Europe is even worse. Of emerging markets strategies, favoured by investors as recently as Q1 this year, only Latin America has managed to stay above an 11% loss YTD, and that’s before hedge funds had a chance to report the losses many no doubt suffered in Brazil on 6 October. Carnage, yes, but bear in mind the HFRI Fund Weighted Composite Index is down only 9.41% YTD, which, compared to the S&P 500 (-19.27% with dividends) looks respectable. It will be hard, however, not to justify simply allocating to government bonds in the current climate, given you’d have only lost 72 basis points over the same period (according to HFR data) with nothing like the same fees. Will this mean a crisis of confidence for investors? After all, hedge fund marketers have been arguing that their managers can make returns regardless of where the markets are travelling, yet it looks to the casual observer that they are failing to live up to their promises.

“We continue to monitor our fund managers closely during this period of extreme market stress,” says Robert Gay, a strategist at Comas, the Commerzbank hedge funds’ platform. “We are fortunate to have a sizeable amount of cash and to have de-levered the portfolios earlier this year. Market distress is also creating opportunities, especially in fixed income and foreign exchange strategies, as well as for liquidity providers in the emerging world. The challenge is to pick the best of breed once there are signs that policymakers are on the right track to restoring global financial stability.”

“Everyone’s sticking their money under the mattress at the moment,” says Nicola Horlick, CEO of Bramdean Asset Management, a specialist investor in hedge funds. “I expect a hiatus in new fund launches now, but while pension funds have been extremely slow to diversify their assets into alternative investments, there is now a real opportunity to expand their allocations from 3% to 10%.”

Horlick admits that the long-term economic outlook “is not that rosy. We have to accept we’re going to see some consolidation in our industry, and like most industries, this one is subject to a certain degree of cyclicality.”

Which begs the question, what is the likely fall-out for hedge funds from all this? Will we see an uptick in redemptions and contingent fund liquidations? Horlick thinks that a lot of listed investment vehicles are now trading at a discount, which will further limit the options for managers seeking permanent capital in the current environment. Other observers anticipate a higher rate of liquidations (Hedge Fund Research reported a 15% rise in the liquidation rate in Q2 against the same period in 2007), but the quality businesses with loyal investor bases are likely to survive.

Counterparty risk

The collapse of Bear Stearns was probably more of a shock to many hedge fund managers than the failure of Lehmans. Following Bear’s acquisition for a song by JPMorgan back in March, rumours continued to circle around Lehman Brothers and managers started paying careful attention to their counterparty risk. Most of the focus was on prime brokers, but other areas of hedge fund operations were also under scrutiny.

Horizon Cash Management, the Chicago-based provider of liquidity and cash management solutions to hedge funds, stresses that problems within the banking system were becoming apparent last year. It removed all financial institutions from its approved credit list when the credit crisis was first evolving. “It’s always been our priority to conduct thorough due diligence on investments suitable for our clients,” says Pauline Modjeski, Horizon’s President. “We continue to find plenty of high quality, liquid investment opportunities which have nothing to do with the financial services sector.”

Horizon, which has been in business since 1991 and currently manages over US$2.5 billion in cash accounts for hedge funds and family offices, has made it a point of investing only in securities with undisputed credit quality, a policy it has had the opportunity to put to the test in a number of financial crises. But cash facilities aside, the consequences of the current banking crisis will be most serious for prime brokers, as the investment banking landscape is completely revised. In particular, those funds which continue to rely on a single prime broking relationship could find themselves in an increasingly precarious position and, while prime brokers might once have frowned on efforts by funds to open new relationships with other banks, they seem now to have lost much of their bargaining power.

“In our opinion, the era of prime brokers securing and maintaining exclusive relationships with hedge funds is now over,” says Sameer Shalaby, CEO of Paladyne Systems. “Hedge funds with single prime brokers (even firms with less than US$1 billion in assets under management), are currently scrambling to balance their assets and manage risk by establishing relationships with new brokers. In the immediate future, many hedge funds will need to take measures to reduce their operational dependence on their primes, actively seeking greater independence and disaster recovery arrangements to protect their assets and operations from third party shocks. For hedge funds with a single prime broker, the sudden collapse of that relationship is devastating. When a prime goes belly up, a hedge fund can lose access to more than its assets; the fund’s very operations can be at risk.”

GLG is just one of the hedge funds which still had counterparty exposure to Lehman Brothers when it went to the wall. On 2 October it told investors that it estimated its combined direct exposure to Lehman Brothers group to be US$95 million, or less than 1% of net AUM. “Since at least the beginning of 2008, in addition to steps taken to significantly reduce our fund assets with LBIE [Lehman Brothers International Europe], we negotiated to more fully protect any remaining assets and transactions through a series of bespoke arrangements,” GLG said. “We have good reason to believe these arrangements were adhered to by LBIE but until we meet with the administrators some uncertainty will remain.”

The fund manager said it would probably write down the estimated exposure to LBIE to fair value in order to be able to publish fund NAVs. Its priority seems to be to ensure that effective dealing can be maintained in its funds with a minimum level of disruption to the investment process.

But the Lehman’s failure has also re-written the roles of the derivatives game. Funds that had attempted to mitigate exposure to interest rate, inflation and equity market volatility may have been hoping that the contracts they were using would perform their required function. But what if the swap counterparty defaults? Martin Johnson, Investment Director at P-Solve Asset Solutions, says the Lehmans crisis has highlighted the increased probability of counterparty defaults and the resulting operational issues for institutions with derivative contracts in place. “Old contracts must be terminated in an orderly fashion, new contracts put in place at competitive rates and collateral calls managed regularly to minimise the potential impact of future market events,” he says.

The prime broker market, once dominated by Goldman Sachs and Morgan Stanley in Europe, and by Bear Stearns in the US, has been transformed and is now seeing newnames pushing into the vacuum left by the blood bath on Wall Street. Banks that are attached to a commercial operation, like Credit Suisse, Deutsche, Bank of America, JPMorgan, and Barclays all have the opportunity now to pick up some of the prime broking market share. Goldman Sachs and Morgan Stanley have moved into commercial banking in an effort to expand their balance sheets and retain vital hedge fund assets.

Paladyne’s Shalaby says prime broking counterparties that are still standing this autumn will probably reduce their service levels as margins fall and leverage is curtailed. In addition, funds will need to focus on their disaster recovery procedures. “With major financial institutions failing or being sold in fire sales, disaster recovery is no longer a ‘what if’ scenario that simply involves housing servers in an off-site location,” he says. “Funds need contingency plans for their entire business model, to ensure that their technology, business processes, counterparty and service provider relationships continue uninterrupted in the event of a financial meltdown or catastrophic event.”

The failure of a prime broker is a good example of one of a “catastrophic event”. Hedge funds, if they have not already done so, should be looking at establishing multiple prime broking relationships as a matter of priority. In addition, there is also some sense in bringing some of the fund’s technical infrastructure in-house rather than relying on prime brokers for everything from the front office trading platform to direct market access algorithmic trading tools.

Politics and regulation

It goes without saying that the current financial crisis has assumed enormous international political implications, and more than one OECD government may end up a casualty of the current turbulence. Just as with the 1997 Asian currency crisis, hedge funds again became the target of the blame game, accused this time of exacerbating the fall in value of banking stocks by taking short positions.

Apart from the criticisms levelled at hedge funds from the usual suspects, including the President of France and the Archbishop of York, regulators on both sides of the Atlantic moved to ban short-selling on specific financial stocks in an effort to exercise some kind of damage control over the banking sector.”The immediate ban is welcome and should be extended indefinitely,” said Michael Fraizer, CEO of Genworth, the Fortune 500 US financial security firm, following the announcement that the SEC would halt short-selling in 799 financial stocks, amongst them Genworth itself. “While short-selling is not the sole cause of the recent market turmoil, I believe it is a major factor and has contributed to the siphoning of billions of dollars of value from American companies. If there is to be any future short-selling, it should be accompanied by regulatory safeguards that absolutely prevent the type of abuses that market has seen recently.”

But the Alternative Investment Management Association, while strongly supporting any measures that might bring equilibrium to the markets, also said that banning the short-selling of financial stocks would bring only temporary relief, and would create an artificial market. It warned that the FSA and SEC’s measures to ban shorting in specific stocks could have unfortunate consequences, including an increase in cost of capital for banks at a time when it is most needed and the incorrect pricing of index products with negative implications for mainstream retail products. “It will not ultimately bring back investor confidence in the banking system,” said Florence Lombard, AIMA’s Chief Executive. She called for an early review of the efficacy of the short-selling bans and their consequences.

This has been born out by the epic plunges in UK banking stocks, all technically protected from further short selling, on 6 October. Royal Bank of Scotland alone plunged 39%, while Barclays dropped 9% and HBOS 42%. According to analysis from SocGen, hedge funds turned net buyers of the S&P 500 following the shorting ban in the US and have also been loading up on commodities like oil and gold, and taking advantage of arbitrage positions amongst high yielding currencies. Shorting banks is not the only game in town, it seems.

The Data Explorers Stock Lending Index (DESLI) indicates that the available loan stock is now in general being more intensely utilised. This implies increased lending revenue from more stock out on loan and the fact that stock borrowing and short-selling remain very active, despite the restrictions in place. Since the bans, stock lending activity has actually risen, with a big spike in Asia, and the volume of inventory has fallen over the last month. Volumes of loans and usage have increased significantly globally, with the exception of the UK, although loan volumes in financial stocks have dropped. According to Data Explorers, the drop in the loan inventory reflects sales of stock by beneficial owners, coupled with what it calls “specific decisions to stop lending these stocks.”

At Bramdean, Horlick thinks the current short-selling issues will focus attention on who is doing the securities lending and could lead to restrictions, self-imposed or otherwise. The Church of England, having criticised short-sellers, suddenly found that it was also actively lending securities and has been for some time. The same goes for many other pension funds. “If I were a pension fund, I wouldn’t lend stock,” she says. “By lending shares you are effectively helping to drive down the price of your asset. Shorting exacerbates falls in share prices, and from the perspective of pension funds is not a very sensible thing to be doing.”


Where does this all leave fund managers? According to the team at Fortis Guernsey, news of their parent’s nationalisation did not prompt a rush for the exit on the part of their clients. Indeed, many were reassured that government ownership would bring a level of stability to its operations. All they asked was that they be kept informed of developments. Other than that, it was business as usual. Sound advice for hedge funds perhaps?