Emerging From the Wreckage

12 months on, how has Lehman’s demise transformed hedge funds?

GUIDO BOLLIGER, CIO, OLYMPIA CAPITAL MANAGEMENT

“Just as diseases spread through contagion, so does confidence, or lack of confidence. Indeed confidence, or lack of thereof, may be as contagious as any disease”
– George A. Akerlof and Robjet J. Shiller, Animal Spirits

Summary
• Hedge funds have had positive net inflows over three consecutive months since the end of May. At the same time, there are still a high number of funds that are closing and only very few new launches.
• We have not seen any significant changes in the liquidity terms and the fees taken by hedge funds during H1 2009. We think that new liquidity terms and lower fees will only apply to newly created funds.
• Following the Madoff scandal, hedge fund managers have put operational risk at the forefront of their concerns internally.
• During 2009, hedge funds have delivered performance in line with investors’ expectations. As of 31st July, the HFR Global Hedge Fund Index is up 7.2%.
• Strategies that performed well in 2008 (global macros and CTAs) are under-performing in 2009.
• Hedge funds have profited from the equity and credit market rally but their leverage remains well below its historical high.
• There has been a significant reversal in the ranking of fund of funds between 2008 and 2009. Last year’s winners are lagging their peers in 2009.
• Risky assets have rallied significantly since March due to both an improvement in the economic situation and massive liquidity flows. Although we cannot rule out continuation of the rally during Q3 2009, we believe asset prices overshot the growth potential of the economy.
• With the stabilisation of the financial system, allocating to hedge funds again provides investors with good diversification benefits.

Introduction
In 2008, the hedge fund industry posted its worst performance ever. Even if hedge funds significantly outperformed equities, they failed to deliver a positive absolute performance during a period where investors needed it most.

Moreover, many hedge funds experienced significant liquidity issues that led them to restrict the liquidity of their funds by implementing gates or side pockets. Finally, the Madoff scandal further tarnished the reputation of hedge funds. By the end of December 2008, some market participants and the financial press had doubts regarding the ability of the industry to survive. Nine months later the consensus opinion is that both hedge funds and fund of funds are here to stay.

The aim of this research is to provide an update on the state of the industry. Clearly we have not returned (and we hope that we will never do) to the “brave new world of hedge funds” that was prevailing before the start of the financial crisis. However, there have been major improvements over the past nine months and we are beginning to gather sufficient information and perspective to provide a good picture of the major trends that have developed, and are set to dominate the picture going forward.

The first part of this document is devoted to the most recent changes in the business and operating models of both hedge funds and fund of hedge funds. It also provides detailed information on the asset flows during the first half of 2009.

The second part of this document provides a detailed analysis of the performance of the industry during H1 2009. More precisely, we compare 2009 performances of both single strategies and fund of hedge funds with their 2008 performances. We also try to understand the source and quality of returns that have been generated by hedge funds during 2009.

In the third part, we provide an outlook for both the industry and the hedge fund strategies for the remainder of the year. The last part of this document draws some conclusions.

PART ONE: MAJOR INDUSTRY TRENDS

Asset flows in the alternative investment industry
Eurekahedge monthly reports indicate that the industry continued to loose assets during the first half of the year (see Fig.1). The total amount of assets invested in hedge funds as of 31st July was $1.35 trillion compared to an amount of $1.47 trillion as of 31st December 2008. This represents a 9% decrease in the total assets invested in hedge funds.

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The good news is that outflows were during the first four months of the year. Between the end of May and the end of July, there have been positive net inflows into the industry of approximately $60 billion. This trend reversal is very encouraging as it indicates that investors are starting to re-allocate money to alternative investments despite the outstanding performance of traditional asset classes. Not surprisingly, the flows for the different hedge fund strategies in 2009 are related to their respective 2008 performance with positive flows into commodity trading advisers (CTAs) and more than 25% of outflows for distressed debt. This is another proof of the tendency of investors to be momentum-driven.

The liquidations of hedge funds have accelerated in 2009: a total of 469 hedge funds have disappeared from the HFR database between 1st January and 30th June. On the other hand, only 60 new hedge funds have been incorporated into the HFR database during H1 2009. This is 60% less than over the same period in 2008. This confirms that the current environment is extremely challenging for investment professionals who want to open new hedge funds. By netting out liquidated hedge funds from newly created hedge funds, one obtains a total attrition rate of 12% over the period. In other words, as of 30th June, there are 12% less hedge funds in the HFR database (our proxy for the industry) than on 31st December 2008.

The lower fees environment has not materialised
Contrary to expectations, there were no significant changes in both the level and the structure of fees taken by existing hedge funds. At the end of 2008, industry analysts expected the level of fees to decrease in order to reflect both the strong decrease in the demand for hedge funds and their disappointing performance. However, people did not consider the fact that, at the same time, the supply of hedge funds also changed significantly:

• The number of hedge funds has declined significantly.
• Surviving funds are of better quality as bad performing funds generally did not survive the crisis.
• Surviving funds tend to be bigger as the attrition rate was much bigger for smaller funds than for long established multi-billion funds.

On top of that, hedge fund managers face buyers who have themselves lost bargaining power (fund of funds for instance) and who are fragmented. Finally, there was also a timing issue as hedge fund investors had almost no new money to invest in hedge funds during the first quarter. During this period, the wave of redemptions was at its culminant point and hedge fund managers were then more than ready to negotiate more favourable terms with investors in exchange for new money.

Given the strong recovery in the performance and the decrease in the outflows, there is a good chance that investors may not be able to negotiate significant fee reductions with existing hedge funds in the future. We think that investors will probably be able to negotiate lower fees with existing managers that are launching new products or with new hedge fund managers as they are still facing significant difficulties to raise money.

There has not been any significant change either in the way performance and management fees are paid out to hedge funds. Rolling and deferred performance fees had been suggested in order to avoid excessive risk taking in an attempt to maximise fees – keeping in mind that paying performance fees is like attributing the manager a free call option struck at the high water mark – or make up past losses. We believe that there will be some changes in this area in the future. These changes will probably be inspired by new rules on the structure of the bonus payments that will be enforced within banking institutions.

The positive consequences of the Madoff scandal
Even if the Madoff scandal caused irreversible reputational damages to the industry, it had one positive consequence: it forced hedge funds to become more transparent, and institutional quality to put operational issues at the forefront of their concerns. Several major industry players have taken the steps to improve the quality of both their operational setting (e.g. designation of an independent administrator) and their reporting. We hope that this trend is an irreversible one. In this context, it will be the responsibility of both investors and regulators to maintain the pressure on hedge funds in order to encourage them to pursue the changes that have been implemented since the beginning of the year.

Be aware of the regulation trap
The financial crisis has shown that banks pose more of a threat to the financial system than hedge funds. Hence, it is highly surprising to see that the EU Commission’s draft directive on alternative investment fund managers has been issued earlier than any concrete new directives on banking institutions. We have continued to reiterate: hedge funds were not responsible for the financial crisis and the ensuing economic recession. On one hand, we view enhanced disclosure requirements for hedge funds as desirable in the interest of managing systemic risk. Similarly, all measures aimed at improving investors’ protection, such as mandatory registration by the SEC, are good for the industry. On the other hand, the part of the directive that suggests prevention of EU investors investing in funds without EU passport is extremely worrying for the industry as we risk facing loss of choice and consequently diminishing returns. We, as hedge fund investors, think that the additional layer of protection that we would receive via this directive is not enough to compensate us for the lower expected return.

This type of over-reaction to market breakdowns (adding inappropriate layers of protection and regulation as fast as possible) is reactive and dangerous. The risk is that, by trying to regulate a market entangled by complexity, regulators may compound future crises rather than extinguish them because inappropriate safeguards add even more complexity which in turn feeds more failures.

Less than 1% of hedge funds have changed their liquidity terms
After the liquidity problems experienced by hedge funds in 2008, industry analysts expected a better alignment between the liquidity provided by hedge funds (e.g. redemption frequency and lockups) and their underlying portfolio’s liquidity. In other words, the expectation was that:

• Hedge funds that provide restrictive liquidity terms but trade liquid instruments would improve their liquidity terms.
• Hedge funds that provide non-restrictive liquidity terms but trade non-liquid instruments would worsen their liquidity terms.

In order to test whether there have been significant changes in the liquidity terms in the past 12 months, we compared the liquidity terms of the hedge fundsthat are in the HFR database as of 30th May 2009 with their liquidity terms 12 months earlier (see Table 1). After exclusion of the duplicates (e.g. different fund classes), the sample of hedge funds contains 2,659 funds. Out of these 2,659 funds:

• 22 (0.8% of the funds) changed their redemption frequency,
• 36 (1.0%) changed their notice period,
• 22 changed their lock-up period.

The vast majority of funds that altered their liquidity terms worsened them: redemption frequency, notice periods and lock-up became generally longer. There are only few funds that improved their liquidity terms. Given the small numbers of funds that altered their liquidity terms, we did not analyse the changes by strategy as they would not be very representative.

It is somehow hard to believe that 99% of the funds that are listed in the HFR database have a liquidity that is perfectly aligned with the liquidity of their underlying portfolio. However, we can’t rule out that some hedge funds have not (yet) reported eventual changes to database providers.

Furthermore, we have seen several hedge funds that, for business reasons, have decided to leave the liquidity of their existing products unchanged whilst becoming much more conservative in their liquidity risk management and that plan to launch new funds with more restrictive liquidity where they intend to give investors access to highly illiquid securities’ returns.

Conclusion
After having experienced a severe contraction, hedge funds have had positive net inflows over three consecutive months since the end of May. At the same time, the number of hedge funds continues to decrease and there have been only very few successful hedge fund launches in 2009. This means that the inflows have benefited the survivors more than the newcomers. Given the reduction in the number of available hedge funds, it is possible that existing hedge funds (the survivors) will not have to decrease the level of fees that they charge to investors. Finally, following a strong pressure from investors after the Madoff scandal, several hedge funds have undertaken significant changes in order to improve their operational framework.

PART TWO: PERFORMANCE OF THE INDUSTRY

Beta-driven strategies are leading the race
As of 31st July, the HFR Global Hedge Fund Index was up 7.2% after a loss of 23.3% in 2008. As depicted by Fig.2, in the long run, hedge funds outperformed all other asset classes both on an absolute and risk-adjusted basis.

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The hedge fund strategies that did well during the first seven months of 2009 are displaying at least one of the following characteristics:

• High exposure to less liquid assets;
• Positive exposure to corporate credit risk;
• Positive exposure to equities and in particular small capitalisation companies;
• Negative volatility exposure or short gamma exposure.

The reverse is true for under-performing strategies. The four characteristics mentioned above are precisely those that have given rise to severe problems and poor performance for hedge fund managers in 2008. As a consequence, as shown in Fig.3, there is almost a perfect inverse correlation between the ranking of hedge fund strategies in 2008 and 2009. In other words, strategies that performed reasonably well in 2008 have underperformed in 2009.

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Hedge funds are no longer in a period of simultaneous distress
CoVaR is the value-at-risk of hedge fund strategies conditional on other strategies being under distress. An increase in the CoVaR indicates an increase in spillover risk among hedge fund strategies. The level of CoVaR also provides a good indication on how much exposure hedge funds have to systemic risk.

As depicted in Fig.4, CoVaRhas been decreasing significantly since the end of 2008. The current level of our CoVaR measure is now below its pre-Lehman level. (Instead of using the absolute value of the CoVaR measure, we use its rank in order to better capture its change through time and normalise its value between 0 and 100). This is the result of:

• The significant decrease in both funding and liquidity risk.
• The significant decrease in correlations within and across asset classes.

This improvement in the diversification benefits provided by hedge funds will lead to a decrease in the volatility of fund of hedge funds.

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Leverage levels are still below historical highs
Given the stabilisation of capital markets, the decrease in volatility, the renewal in risk appetite and the improvements in financing conditions, one might assume that hedge funds have increased leverage during 2009. We use the absolute value of the dynamic (Kalman filter) beta exposures of hedge fund strategies as a measure of leverage. This measure is far from being perfect but it gives a good proxy of the tendency towards leverage within the hedge fund industry.

Fig.5 demonstrates the leverage of hedge fund strategies as of the end of July 2009 as compared to the averaged 2008 level as well as historical highs. We clearly see that:

• The industry is still on a defensive stance as the level of leverage is far below historical highs.
• Most of the strategies are still running at leverage levels that are below their 2008 level. The most defensive strategies being CTA and global macro whereas the most aggressive ones are relative value strategies which are, by their very nature, the biggest consumers of leverage.

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These results are reassuring for three reasons. First, they show that hedge fund managers have learnt from the crisis as excess leverage was the worst performance detractor of the industry. Second, despite the significant decrease in volatility, there are still significant uncertainties regarding the long-term shape of the economic recovery and the historically low leverage numbers indicate that hedge fund managers do acknowledge it. Finally, they also demonstrate that hedge funds do not need excessive leverage numbers in order to generate good returns if the volatility is sufficiently high.

Hedge fund strategies exposures
One of the main advantages of hedge funds over mutual funds is their ability to dynamically allocate their risk across or within asset classes in response to changing market opportunities. We report the risk exposures of hedge fund strategies in Fig.6. These exposures are computed by stressing major risk factors and measuring the impact of these stress tests on the return of the strategies. It is important to note that we take the correlations between risk factors into consideration. For instance, if we stress the MSCI World Index, it will also stress both the S&P 500 and the MSCI Europe indices which are positively correlated to the MSCI World. This gives us a better picture of the strategies’ exposure but can lead to some spurious results especially after a period of very high correlations across risk factors like during the second half of 2008. We will not discuss the results for each strategy in detail, but there are four important points that emerge from Fig.6:

• Hedge funds have been able to profit from the equity and the credit market rally as all hedge fund strategies that traditionally invest in these asset classes have a positive exposure to either equity (WLD EQTY) or credit markets (HY Spds); some strategies (e.g. credit arbitrage) have exposures to both.
• These same strategies are now significantly short equity market volatility (VIX). As a consequence, they are now much more vulnerable to a significant increase in market volatility.
• With the exception of a significant (but probably over-stated) short dollar exposure (DXY), global macro managers are running very defensive portfolios. This reflects the general scepticism of global macro managers regarding the sustainability of the economic recovery.
• Short-term CTA is the only strategy that provides protection against an increase in equity (VIX), interest rates (MOVE) and currency (FX G7) volatility.

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Fund of funds: last year’s winners are this year’s laggards
As of the end of July 2009, the Eurekahedge fund of funds index was up 5.6% for the year after having lost 19.5% in 2008. In order to determine which fund of funds performed the best in 2009, we have ranked all fund of funds of the HFR database that are still alive as of 30th June 2009 based on their 2008 performance and then computed the 2009 year-to-date performance of each rank decile. For instance, the members of the first (10th) decile are the 2008 best (worst) performers.

By looking at Fig.7, one can clearly see that fund of funds that performed decently in 2008 are lagging in 2009. The rank correlation between the 2008 and 2009 returns of the different deciles is close to one at -0.85. The main explanation for this significant reversal is to be found in the reversal of the hedge fund strategies’ performance that we outlined above. In 2008, the losers were punished for aggressive allocations in strategies and hedge funds that were heavily exposed to illiquid instruments and that were running leveraged directional portfolios. This year however, the 2008 winners’ asset allocation was heavily tilted toward liquid and less levered strategies such as global macros and CTAs that are lagging significantly in 2009.

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One could conclude from this that some fund of funds’ managers have a static asset allocation and a very low forecasting ability for outperforming strategies. This is not entirely true. Indeed, during the first half of 2009, fund of funds (both winners and losers) faced significant outflows which forced them to maintain their portfolios as liquid as possible. In these conditions, it was nearly impossible for last year’s winners to invest significant amounts in less liquid managers. Similarly, given the number of hedge funds belonging to the 2008 losing strategies that restricted their liquidity at the end of last year, a significant number of the losers’ group likely had no other choice but to stick with their 2008 positions.

Conclusion
The performance of the hedge fund industry has clearly improved during H1 2009. This good performance is mainly due to beta driven strategies and exposure to illiquid financial instruments. Furthermore, the performance of hedge funds in 2009 was not achieved via excessive leverage as the high volatility environment that prevailed until the end of Q2 2009 did not necessitate high level of leverage. With the stabilisation of the financial system, the vulnerability of hedge funds to systemic risk has come down. As a consequence, if there is no revival of systemic risk, hedge funds should be able to provide diversification whatever the future direction of financial markets. Finally, the reversal in the performance of hedge fund strategies in 2009 caused reversal in the performance of funds of funds: last year’s winners are generally lagging their peers in 2009.

PART THREE: WHAT CAN WE EXPECT FROM THE INDUSTRY?

Markets are back in a low risk regime
With the stabilisation of the financial system, investors’ risk appetite has increased significantly in 2009. The aggregate level of risk in the financial system has decreased to levels that are close to the pre-crisis (July 2007) ones (see Fig.8). Given the high economic uncertainties that are still prevailing, wethink that this move is highly premature. As a consequence, we would not be surprised to see an increase in the volatility of risky assets during the forthcoming months.

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The probable end of expansionary fiscal and monetary policies
Central banks and governmental actions have been able to restore financial stability and stabilise the economy. The period of both monetary and fiscal stimulus is now probably over and both central banks and governments will start to think about the long-run situation of both their economies and their budgets. At the same time risky assets have rallied significantly reflecting the improvements in the global economy but also as a consequence of massive inflows of liquidity. In our opinion, the recent price appreciation of risky assets goes beyond what the potential growth of the economy might justify. It can’t be ruled out that it will continue for a while based on further (but transitory) economic improvements and further liquidity inflows on the part of investors that have missed the start of the rally. However, in the long run, asset prices cannot keep exceeding the growth potential of the economy without the rally morphing into a speculative bubble.

In these conditions, we view three possible scenarios ranked in order of likelihood:

• At the end of 2009 or earlier, markets start to be impacted again by fundamentals rather than by technicals (liquidity) and this will translate into a contraction in both equity and corporate bond prices in order to better reflect the fundamental economic situation.
• Risky asset prices continue to rise at this pace for the next six months and this leads central banks to tighten their monetary policy sooner than the market expects.
• Risky asset prices continue to rise at this pace for longer than six months resulting in a new speculative bubble (and we all know how those always finish up).

Conclusion
After the disappointing performance posted by hedge funds in 2008, hedge fund investors expected the industry to question its internal practices and improve performance. Regarding practices, we view the improvement in both the operational setting and the transparency of some hedge funds as very positive. However, as outlined in this research, we believe that there is still room for further improvements in the way hedge funds structure their performance fees, in the liquidity terms provided to investors and also to a great extent in the quality of their reporting.

As far as performance is concerned, there have been major improvements. The major driver of this improvement is the return of liquidity on global markets as liquidity is the key ingredient for steady returns for hedge funds over time. In regard to the current conservative level of leverage used by the industry, we believe that managers have drawn lessons from what happened in 2008.

We clearly hope that the volatility of risky assets will not return to its July 2007 levels for a long period of time. If markets were to become that complacent, not only hedge funds but the whole economy will probably be highly levered again and it will be time to think about the burst of the next speculative bubble.