Financial Crisis and Hedge Funds

Industry experts give the inside track

INTERVIEWS BY VINCE HEANEY



Sarah Bowles, Partner and Head of the Financial Services team and Richard Perry, Partner in the Financial Services team at Simmons & Simmons

Short-selling restrictions

SB: “Real problems have been created for some hedge funds in the UK, US and other areas such as Australia where there has been a complete ban on short-selling in financial and, in the case of Australia, other stocks. Merger arbitrage strategies, for example, cannot be executed without a short position and black box quant strategies may no longer provide valid signals if a large chunk of stocks has to be removed from the model.”

“Short-selling regulations continue to change, and some jurisdictions have extended the scope of earlier restrictions. But, looking at the model adopted in certain jurisdictions; which bans naked short-selling and requires some form of disclosure of short positions, that at least is manageable. There is a scramble to understand and comply with the new regulations, but at least in those jurisdictions hedge funds can continue to trade.”

“Prior to the ban the FSA consistently said that short-selling was a legitimate activity that assists market liquidity, so the restrictions should be temporary. Whether the ban is lifted or extended in January will depend on the state of the markets.”

“There was some question, back in June, whether the FSA’s new rules on short-selling during rights issues were legally permissible. But there appears to be less room to challenge the basis on which the latest ban on short-selling was introduced. The FSA has the ability to act without consultation when there is a need to protect consumers, and the regulator used this justification when introducing the ban. Our clients are focusing on compliance rather than potential litigation.”

RP: “Investors, on the other hand, won’t be able to use the short-selling ban as a reason for pulling their money out of a hedge fund immediately. There is no concept of force majeure for investment in a hedge fund and investors would have to exercise their normal redemption rights under the constitutional documents of the fund vehicle.”

Prime broker relationships

SB: “The reason the prime brokerage model was attractive was that costs for users were low. By allowing re-hypothecation and not ring-fencing their money with their brokers hedge funds kept costs down.”

RP: “Re-hypothecation is the focus of attention for a lot of hedge fund managers at the moment. In future, there’s likely to be less re-hypothecation, more ring fencing and, in the short term at least, there will be fewer prime brokers. The business model of the prime brokers will also change and they may have to charge hedge funds more for other services if they are unable to put the funds’ assets to work. Greater protection of assets will come at a price.”

Effect on own business of recent events

RP: “Four areas are keeping us busiest at the moment: the ban on short-selling; the valuation of funds’ exposure to Lehman Brothers; prime brokerage and counterparty issues and the shifting of custody relationships; managing significant redemptions from funds: how do you pay out without prejudicing remaining clients?”

Future shape of the industry

RP: “We’re still doing new fund launch work. Redemptions have been most significant from funds of funds, while there is still new investment from pension funds into hedge funds. The trend for pension funds to increasingly move beyond funds of funds to direct hedge fund investment remains intact.”

“There’s a strong sense that investors are putting in redemption notices for greater amounts of capital than they will ultimately redeem. Redemption notices served may not be an accurate guide to eventual withdrawals.”

Philippe Teilhard, Global Head of Prime Brokerage at Newedge

Prime broker relationships

PT: “There’s a big premium for bank-owned prime brokers at the moment. If you are bank-owned and also carry out no investment banking activity then you are even more highly sought after. On top of the issue of financial safety, avoiding the embedded conflict of interest of dealing with someone engaged in trading activities within its investment banking business is key.”

“Some prime brokers’ models have been to offer cheap services to attract hedge fund money with a view to trading off the back of the flows. Newedge is the complete opposite to this model. We are a service agency prime broker. We have noproprietary trading and, whilst owned by two big AA-rated banks, we have our own banking licence and governance. Fortunately for us the business model that we chose is in a sweet spot in the current environment.”

“The choice to use more than one prime broker is not just a function of the current turmoil. When prime brokers were selling themselves as strategy specialists, for example in equity long/short or fixed income arbitrage, hedge funds used to have more relationships for commercial reasons. Prime brokers would compete on the price and the amount of leverage they were prepared to offer. With the emergence of multi-strategy funds and increased use of derivatives in equity-based strategies, posting margin with a number of prime brokers was an inefficient allocation of capital: funds needed a PB with cross margining ability.”

“I suspect that there will be more due diligence by hedge funds about how prime brokers are managing re-hypothecation; who the prime broker is lending to and to what extent. If you have a top flight prime broker then the risk is highly mitigated, but if you have concerns about the prime broker’s ability to manage the chain of how assets are used, then you are going to be more concerned about re-hypothecation.”

Short-selling bans

PT: “We believe shorting is an essential tool for market transparency and is one of the key processes in price discovery. Short-sellers also provide the much-needed buyers when markets are in dire straights. I think most market participants believe this, but the issue has become highly political. I suspect the bans will be temporary, but short-selling may be subject to more controls in future.”

On the future of the industry

PT: “Everyone, governments included, was happy to have low interest rates, competitive disinflation, globalisation and massive asset price inflation. But the party is over and de-leveraging is a painful process. We are entering a world of higher equity ratios to risk weighted assets and less leverage in balance sheets. The overcapacity in the financial industry is correcting itself and we will see fewer big players in future.”

“But the biggest casualties are the long only asset managers. Even the actively managed part of the industry is in trouble because of their inability to beat their assigned benchmarks in a repeatable fashion. The ETF industry has a lot of wind in its sails, it’s low cost, is here to stay, will continue to grow and push the traditional long only industry to the fringes.”

“Overall this year will be a bad year and a write-off in terms of asset growth for hedge funds and not necessarily because of performance. Redemptions will hit even the strategies that continue to deliver strong performance in the current volatile environment. But absolute return strategies are here to stay. Hedge funds manage about US$2.5 trillion compared with a US$25-30 trillion global pension fund industry. Accelerating pension fund inflows will help the hedge fund industry double in size over the next few years if pension funds increase their asset allocation by 10% to hedge funds.”

David Stewart, Chief Executive of Odey Asset Management

Short- selling bans

DS: “The impact that shorting has had on banks has been grossly exaggerated. One or two funds were caught in the initial short squeeze as the bans were implemented, but a lot of de-leveraging had already taken place. I think short- selling of financials will be allowed again fairly soon as it is so apparent that the ban was a red herring. The main issue was poor lending and a lack of capital. The rescue package for UK banks is now the only thing to do.”

The future shape of the industry

DS: “With the greater involvement of governments the system has become less capitalist and more socialist. The industry, therefore, will have to be more inventive about alpha generation.”

“There will be consolidation and it will be a Darwinian process. Those that can demonstrate reliable 10-15% compound returns will attract business and those who were up 50% and are now down 50% will not. However, it is worth remembering that while the performance of some hedge funds has been poor the performance of certain traditional long only funds has been very poor.”

“The time has come to be more discerning about using the term ‘hedge fund’. There is a marked difference between the highly leveraged, proprietary trading desk wizardry of recent years and a more old fashioned approach: an incarnation of the old balanced fund, that looks to protect capital, deliver absolute returns and be uncorrelated to the market.”

“The point I would make to the FSA is that funds following this ‘balanced’ approach have delivered more certain returns than many long only funds and, therefore, should be suitable for retail investors. The industry should say to the FSA, ‘yes, we’ll accept greater regulation for the product but let us sell to retail clients.’

Prime broker relationships

DS: “When I came into the business I initially wondered why hedge funds used prime brokers rather than custodians and the answer was that re-hypothecation did reduce the costs of doing business. The issue is that the agreements that were written presumed only the hedge fund could get into trouble. This has all changed now.”

“Rightly the model is moving towards custodial relationships. The costs of doing business will go up, but if there’s one thing I’ve learned it’s that you want your liabilities to be with a bank and aligned with the depositors. If the banks, and the investment banks that now have banking licences, can get their act together they can clean up in the hedge fund custody business.”

Greater regulation

DS: “Regulation is sadly backward looking. The horse has bolted and invariably they will now shut the stable door and, yes, I think there will be an attempt to regulate hedge funds in some way. In the medium term, tighter regulation may also remove some of the entrepreneurial talent from the sector or drive it offshore.”

The effect on own business

DS: “We are not actively marketing at the moment. We have strong demand for our funds and until liquidity in markets improves we do not want to get much bigger. When liquidity dries up you need to be small to deliver the right performance.

Liquidity is central to the hedge fund debate and we have built our brand on the liquidity we offer in our hedge funds. For us lock-ups are dangerous. They allow managers to build illiquid positions, feeling safe because of the lock-up, but losing some of the investment disciplines as a result. In this situation by the time investors get their money back they are so angry that the relationship is broken.”

Ken Kinsey-Quick, Head of Multi-Manager, Thames River Capital

Short-selling bans

KK-Q: “Despite short-selling bans, financial stocks have continued to fall. This has done hedge funds a favour as it has shown the public and regulators that the funds are not to blame. The worst that could have happened is if, coincidentally, the market had rallied after the bans and regulators had misinterpreted the bounce to pin the blame on hedge funds.”

“The US has lifted its ban, but it’s still in effect in the UK and financial stocks have still plummeted. You can’t blame renewed selling pressure on the lifting of the ban.

“On the first day after the US ban was lifted most of the weakness in the S&P 500 was at the close. If short-sellers had been lining up to sell, the market would have started weaker, when in fact it was up on the day for a while. It was in the afternoon, when mutual funds with daily dealing know what their redemptions will be, that the market fell.”

“Short-selling makes the market more efficient. The credit markets have been hammered, but equities have still been pricing in some earnings growth. Equities are now adjusting, and all that banning short-selling has done is to slow down that process.”

The future shape of the industry

KK-Q: “The industry needs a clear out. It has been a bit like the California Gold Rush with everyone turning up with a pick for the chance to earn 2/20. We are going to see the highest level of attrition the industry has ever seen, although it’s impossible to know what the actual level will be.”

“The impact on markets over the next three months from hedge funds having to unwind their portfolios to meet redemptions won’t be as great as many people think. For a start, most managers don’t have over-leveraged balance sheets. Prime brokers have already slashed the lines they will extend to funds, particularly since the collapse of Peloton. Also, in current market conditions it’s prudent to have a smaller balance sheet and higher cash holdings.”

“I think we are reaching the point of maximum capitulation and the equity market will reach a bottom in October. Over the last year, the sell-off has been more technical, driven by the state of the banking system. Over the last month, the selling has been based on the fundamentals: we’re probably at fair value pricing for a recession, but the markets will overshoot. Don’t expect a V-shaped recovery though, it’s going to be more like 1973-74, when the market didn’t regain its previous peak until 1981.”

“When people look back on 2008, hedge funds may well have lost 10% in aggregate, but the broad indices may have declined by 40%. Investors are going to realise they should have been in hedge funds.”

“If markets fall by 50%, then they have to rally by 100% to get back to the high water mark. You will need 15% annualised returns for more than five years just to get back to where you started. People will realise that you need absolute return vehicles and we will see a massive shift in investment towards hedge funds.”

The effect on own business

KK-Q: “Up to the end of September, our fund of funds business had grown by 40%, although in the fourth quarter we will see about 3% redemptions.

Relative to some others we have protected capital and that positive experience has led to increased subscriptions.”

“We are embarking on a big marketing campaign. The key message to clients is that we are reaching the point of maximum capitulation so it’s pointless running for the exit now. It’s time to add to your portfolio.”

Andrew Baker, Deputy Chief Executive, AIMA

Short-selling

AB: “The function of a short-seller is to cry from the rooftops when there is a problem. It’s wrong to shoot the messenger. Is it less moral to say a building is a fire risk than to continue to lead paying tenants into that building?”

“After the short-selling bans, while the focus has been on the impact on hedge funds there is a more insidious long-term effect, which is the erosion of the price-setting mechanism, through wider spreads, higher volatility and an increased cost of raising new equity capital. The perception that regulators can intervene on a whim erodes confidence in the price-setting mechanism.”

“I hope we can believe the pronouncements made when the bans were introduced that they are temporary, and hopefully temporary won’t mean one day short of eternity. Now that the UK has announced a rescue package for the banks, they should at least relax the ban to allow covered short-selling.”

The future of the industry

AB: “Redemptions will be the highest ever at the end of September. But a lot of pre-emptive redemption requests have been submitted to establish a place in the queue for the exit. You can always step out of the queue.”

“Funds also have a duty to protect remaining investors. You don’t want to end up with a disproportionate amount of illiquid assets in the portfolio and funds may have to impose a gate or suspend NAV.”

“It’s likely to be grisly: a net redemption year. But it’s extraordinary that so far the funds that have gone out of business have done so in an orderly fashion. There’s no dishonour in an orderly closure.”

“At some stage there will be a great wake up and investors will realise that they need absolute return vehicles. My number one prediction for next year is that there will be a name change, as ‘hedge fund’ has become a term of abuse. When the panic is over, there will still be a need for hedge funds to be part of the intermediary mechanism that allocates capital efficiently.”

“There will definitely be fantastic opportunities. There’s not a capacity problem in the industry, it’s just that when all asset classes fall together, volatility is very high and the regulators change the rules, it’s very difficult to make money.”

Prime broker relationships

AB: “It’s almost academic. In the space of a couple of weeks the market has given its judgement on the issue of prime broking. From now on it will be the preserve of the biggest banks. Also the mantra of the one-stop-shop has backfired. You need counterparty diversification as much as portfolio diversification.”

“Re-hypothecation appeared to be a free lunch, where your investment was safe but you could borrow against it. But there’s a trade off between security and the cost of financing and we will now return to a more reasonable assessment of it. Re-hypothecation won’t disappear completely: funds never had the negotiating power to put a limit on it before, but they have that power now.”

Regulatory creep

AB: “Our view is that hedge funds are not the primary target of new regulation, but inevitably will get caught in the crossfire. The populist backlash against financial services is underway and the political response to that will prompt greater regulation. But the current problems are a failure of existing supervision, not a lack of rules themselves.”

“The more rules you apply, the more people will try to circumvent them. You can’t regulate away human behaviour. What you need is smarter regulation not more regulation.”

“Investment banking activity could easily shift into hedge funds, to avoid regulation. But regulators will be keen to prevent that, otherwise you risk sowing the seeds of the next crisis.”

Chris Manser, Head of Fund of Funds, AXA Investment Managers

The future of the industry

CM: “Given the issues in the financial system it’s no wonder that hedge funds and funds of funds are seeing redemptions. But it’s important to stress that the future of the hedge fund industry is linked to the future of the financial system, not the other way round. The scale of the problems in recapitalising the banks is much larger than the potential de-leveraging at hedge funds and funds of funds, which will not break the system.”

“Clearly the industry’s performance numbers have been challenging, but some funds and funds of funds, ourselves included, have protected their capital completely or suffered only slight losses. That relatively good performance will promote investment; after cash and government bonds, hedge funds are still the best performing asset class.”

“The industry’s prospects are also different to other asset classes. You don’t need a recovery in equity markets or a tightening in credit spreads for hedge funds to make money, as they can hedge out the directional risk and focus on relative value. At the moment risk aversion and technical selling are driving the markets, but when you get a normalisation of market conditions, fundamentals will play a bigger role again.”

“There has already been a significant increase in the dispersion of returns in the hedge fund and funds of funds sector. Looking at the potential redemptions in the system, this will clearly result in greater, not less, dispersion. From Axa’s viewpoint we are comfortable with this trend as we have a stable investor base.”

Strategies likely to benefit

CM: “Going forward there will be fewer players and less competition from proprietary traders. There is a big question, too, over how much leverage will be available. But at the moment you don’t need to use a lot of leverage to generate returns.”

“You want to be in liquid strategies, otherwise you are just taking a punt on whether there will be an asset price recovery. That clearly means investors should look at global macro and CTA strategies.”

“Volatility arbitrage has good prospects, if we are correct that volatility won’t return to exceptionally low levels. There is also going to be an opportunity in distressed investing, although not for the next six to nine months, but after that, as the credit cycle unfolds, it will be an important area.”

Regulatory creep

CM: “While I hope that there is still a path to greater transparency and self-regulation rather than greater government regulation, it could well be that hedge funds will be more regulated than in the past.”

“We’re already witnessing the public push back against hedge funds. It’s reasonable to expect that the public will push for more regulation. Also if investment does shift towards hedge funds in future, then regulation will be more imperative.”

Impact on own business

CM: “We have attracted more capital over the year and haven’t seen any significant levels of redemption. With the stable asset base and the corporate backing that we have, we see ourselves as a beneficiary of the turmoil.”

“You don’t stop marketing. It’s important to maintain the dialogue with existing and potential investors, to show the client that their downside is protected and where you see the upside.”

Ken Heinz, President, Hedge Fund Research, Inc.

Short-selling

KH: “If the policy intent behind the ban on short-selling is to reduce short-term destabilisation then it makes a lot of sense. It’s difficult to extract the impact of a ban from the rest of the factors influencing prices, but while short-selling can have an effect over a short period of time, in particular stocks, it’s difficult to argue that it has any aggregate impact on the market.”

“Short-sellers are just economic agents, they are not responsible for the earnings declines at the companies whose stock they are selling nor the issuance of bad loans. The effectiveness of the policy in light of the number of potential negative external consequences is also questionable. Under the restrictions the cost of shorting has increased marginally, but it’s still possible to structure a short exposure. The increased complexity, however, has also increased the opportunity as shorting has become more difficult.”

The future shape of the industry

KH: “In the first half of this year, 350 funds liquidated, which was an increase of 15%. The number of new fund launches declined compared with last year, but the total for the first half was still 487. Despite the markets’ volatility, there was a net increase in the number of funds and a net increase in capital in the industry, although both grew at a much lower rate.”

“Taking account of the exceptional volatility in the third quarter, if the pace of liquidations increased by more than 50% in the second half so that 1000 funds liquidated, that would represent 10% of the industry. If you then assume that after the 487 in the first half and make the most conservative estimate possible that there were no more new fund launches this year, then the net decline in fund numbers would be 5%. It’s obviously difficult to say whether or not the worst is behind us, but suggestions that the 10,000 funds in the industry could shrink by a third aren’t consistent with other patterns of consolidation or financial crises which have been observed historically, and thus are not substantiated by the data.”

“If you look at the dispersion in performance in the 12 months up to the end of the first half of 2008 it was 75%, which is the widest since 2003. The top 10% of funds posted gains of 50%, while the bottom 10% posted losses of 25%. Over that period the overall HFRI index was down by about 1%.”

“It’s plausible that part of the consolidation takes the form of a reallocation of capital from under-performing funds into out-performing funds rather than an overall withdrawal of capital. Consolidation might be a combination of a net industry redemption and an allocation of capital to those managers that have proved they are able to perform in the toughest environment.”

“The current environment will create opportunities. We don’t know if September 2008 will be the low point of the market, but the drawdown in hedge fund returns has already being going on for 10 months since the high water mark in November 2007. If we look at the five biggest draw downs in hedge fund history the longest was four months, so we have already exceeded that by two and a half times. On average the recovery in the broad HFRI index in the 12 months from the low point of those five biggest draw-downs was 16%.”

Tony Morrongiello, Managing Partner and Head of Research, Caliburn Capital Partners

The future of the industry

TM: “Fears about the extent of possible redemptions are well founded. The hedge fund industry is waking up to the liquidity mismatch that has always existed in the business. Liquidity provisions have now been tested that were never meant to be called upon. Some asset-backed strategies, for example, offered quarterly redemptions with a 45 day notice period, but in that time frame you could only liquidate 20% of the portfolio, not more.”

“Accidents happen, usually not because of one event but because of a series of exogenous factors. Not only is there the issue of the underlying liquidity of hedge fund investments and whether you have the funding in place for them, but also the liquidity offered by investors. Hedge funds have been seen as liquidity providers, but investors also have to be prepared to provide liquidity.”

“Size won’t be the only determinant of which funds disappear, it’s really down to the liquidity mismatch and the nature of your client base.”

“Institutional investors will have to ask themselves how they are going to allocate their assets following this massive dislocation. Their traditional mix of equities and bonds is no good, different sources of return are needed and hedge funds are part of that.”

Strategic asset allocation

TM: “The private client network has relied on stable hedge fund returns with low volatility in all market environments. At Caliburn we have been saying for a long time that the model of a hedge fund as a Master of the Universe, capable of delivering returns in all market conditions is no longer valid. The Master of the Universe has left the building. Now it’s all about strategic asset allocation. The big picture is more important than picking investment styles. You have to find areas that are less crowded and less efficient.”

“A lot of fund of hedge fund allocators have delegated responsibility on asset allocation to their underlying hedge fund managers, but you have to go back to basics and have a view of the world. It will take a long time for equity markets in the developed world to recover. At Caliburn we have had a non-US centric view of the world, which over the last few months has of course suffered a set back. However, global economic growth will continue to be driven by the developing world and investors will increasingly gravitate towards these sources of growth”

“The fund of funds industry will have to acquire strategic asset management skills. It’s about getting the big picture right and that’s difficult. You don’t need to be calling the dollar correctly, but you have to spend time understanding the engines of growth, for example, the composition of Chinese GDP. A local presence in emerging markets is essential.”

Favoured strategies

TM: “Some overcrowded strategies are now less crowded. In the credit space for example, hedge funds will be able to pick up the pieces at very attractive levels. We have been sceptical about the opportunities for distressed credit for the last year, but that strategy’s time is now getting closer.”

“It’s less likely that hedge fund strategies can thrive in developed markets in a deflationary environment with a lot less leverage. There are some tremendous stores of value in pockets of

the emerging markets, such as Brazil and Russia: you don’t have to go to the frontiers of emerging market investing to find opportunities.”

“The fundamentals are being ignored right now. Sectors of the equity market are getting annihilated without regard to valuation. When markets stabilise, hedge funds should be able to make good returns and basic stockpicking will do well. For example, you can be less constructive about the oil price because of the slowdown, but if an oil company is finding reserves and they are valued at a quarter of today’s price then it can offer value.”

Marina Lewin, Senior Managing Director in Fund Administration, The Bank of New York Mellon

Prime broker relationships

ML: “Our hedge fund clients are making sure that they have access to their assets although there is not just one single way of doing that. They are using commercial banks as custodians in some cases or using multiple prime broker relationships. Hedge funds want to put their assets where they feel sure they will remain unencumbered, they can’t tolerate a Lehman-type situation.”

“At the moment hedge funds are concentrating on protecting their assets, so there is probably less long-term thinking going on. But the prime broker model was injured by the collapse of Bear Stearns and now its really damaged. The balance between the commercial banks and the brokers with regard to who does what will alter, although it’s still too early to know the details. For example, Goldman Sachs and Morgan Stanley now have commercial banking licences, so how will that impact the model? Also, the way in which the CDS market ends up being regulated will have an impact. But I do think the model will never be the same again.”

Effect on own and clients’ business of
recent events

ML: “We see ourselves in a strong place in the current environment. We have benefited from the need for hedge funds to find a safe place to put their assets and have attracted custody assets. Also, we have benefited from a flight to quality among administration clients.”

“There’s no question that new fund launches, while they have not stopped, have slowed down. Also, launches are taking longer to get off the ground. Interestingly we have recently seen a couple of funds, which having been waiting to launch since February, decide to launch now.”

“Some hedge funds are now structuring their funds as private equity funds. With that structure they only call in funds when they are needed and lock-up periods are longer than at a traditional hedge fund.”

“Credit restrictions and counterparty concerns are contributory factors to the de-leveraging at our hedge fund clients. But market risk exposure, the fund’s performance, the desire to avoid excessive volatility and unanticipated redemptions are also playing their part. It’s a bit early to see a pattern in redemptions, because of the three month notice period investors have to give. It will be interesting to see how many of the redemptions are actually acted upon.”

“Anecdotally, many hedge funds are sitting on cash balances: both to meet redemptions and also as an investment decision. We have also seen a tremendous flight to money market funds.”

Future shape of the industry

ML: “Hedge funds are ultimately arbitrageurs who seek opportunities when markets are out of balance. I have to believe that we will get back to a situation where hedge funds can exploit those opportunities profitably.”

“Anecdotally there is evidence to support the trend that funds are getting bigger and more institutionalised, which may make them more attractive to institutional investors. But institutional investors have fiduciary responsibilities and are averse to the headline risk of losses. They may have less tolerance for losses from absolute return strategies even though those losses may be smaller than those incurred on traditional long only investments.”

Drago Indjic, London Business School’s Hedge Fund Centre

Liquidity mismatch and the need to separate alpha from beta

DI: “There is a mismatch between portfolio liquidity and the liquidity offered to investors, although we are more concerned about the stress funds of funds are under than underlying hedge funds, especially those exposed to retail investors.”

“Funds of funds are a monolith, which lumps alpha and beta together in an integrated portfolio. They need to restructure. For some time they have been the exclusive distribution channel for hedge fund alpha and beta. It’s time to disentangle illiquid alpha from liquid beta and in future there will be a greater range of products offered. For example, at the moment if a large fund of funds suffers a big redemption they will be forced to close out liquid positions, leaving the fund of funds more illiquid than before.”

“Because the fund of funds business model is under stress, investors will need to expand their sources of alpha and beta generation, including using more hedge fund replication and other synthetic solutions.”

“The concept of funding liquidity stress testing is also very important. Hedge fund investment products have not been designed with liquidity stress testing in mind. Funds of funds lack the accurate models to be able to carry out a proper analysis of, for example, how quickly can other investors redeeming later get their cash back in the event of large-scale redemption by the largest investor, and how different their beta exposure will be from the ‘first to get out’ investors. This is a shortcoming that we have been pointing out for a considerable time.”

Attrition in the hedge fund and fund of funds industry

DI: “The only people with a clear idea of the rate of redemptions giving rise to fund attrition right now are fund administrators. The view of the world available through hedge fund databases is incomplete and subject to a time lag of three to six months. It won’t be possible to form a view on the attrition rate based on the data until the first quarter of next year. Everything else is just pulling numbers out of thin air given that, if conditions change, most of the redemption notices that have been submitted can be cancelled.”

“Of course, this is a good illustration that the data quality standards of the hedge fund industry should be increased, otherwise it won’t be possible to draw firm conclusions. Whether that falls to industry trade bodies or IOSCO, surely it cannot be acceptable that only a few academics can count the number of hedge funds in London or measure the liquidity mismatch in the fund of funds sector?”

“It is still unclear what investors will do when faced with a double-digit percentage loss at the end of the calendar year. There are two different paths they can follow: redeem and move into cash, crystallising the loss and then waiting or immediately invest capital in something else. The industry fees cannot be justified for delivering significant exposure to cash or pure beta.” THFJ