The End of an Era

But what lies ahead for hedge funds?

Originally published in the November 2008 issue

A sign of the times has to be the Asia-based hedge fund manager who recently confessed to me that he no longer admits to being a hedge fund manager at social functions, instead opting for something more generic, like ‘asset management’ or ‘financial services.’ “There is some real animosity out there directed at hedge fund managers and investment bankers,” he says. “I’ve never seen anything like it before.”

And he’s not just referring to the newspapers, either. The man on the street is now in the process of forming a view that hedge funds are not a good thing, not good for the markets, not good for business and not good for the economy. Despite the best efforts of industry bodies like AIMA (the Alternative Investment Management Association) and the Hedge Fund Standards Board, hedge funds are still losing the public relations war in a world where bad PR can break the biggest business, the most confident politician, seemingly overnight.

For five senior hedge fund managers to be summoned before Congress to testify on the industry’s role in the market crisis of recent months is a good indicator of where the political wind is blowing. George Soros, John Paulson, Ken Griffin, James Simons and Philip Falcone all testified before the House Committee on Oversight and Government Reform on 13 November. It was obvious, from the start, that it would be very difficult for them to defend the status quo, and their testimonies reflected the fact that they, and no doubt a large slice of the US hedge fund constituency, recognise that some kind of enhanced regulatory regime is in the works. Just how radical it will be, and how heavy its impact on hedge funds, will depend on a variety of factors, some outlined here and elsewhere in this journal.

Whether the hedge fund industry will even be properly consulted is also open to question: while Soros et al claimed their readiness to aid the US government in its efforts to devise a new regulatory regime for hedge funds, in recent months we have seen regulators move to ban shorting in financial stocks with virtually zero industry consultation. This has set a precedent.

Many managers will also be focused on investor morale. Who is submitting redemption requests? Who is thinking about submitting redemption requests? And who is on board for the long haul, or at least says they are?

Don’t be fooled by the numbers
Hedge Fund Research has estimated that steep performance losses experienced by many hedge funds coupled with record investor capital redemptions has reduced the size of the industry’s AuM by approximately US$210 billion in Q3. This represents the largest historical quarterly decline in assets since 2005, with investors withdrawing US$31 billion during this period, the largest net capital redemption in the history of the hedge fund industry.

The third quarter withdrawals entirely offset capital inflows in the first half of this year, bringing year-to-date net outflows to US$2.5 billion. The decline in industry assets for the third quarter also exceeded the total amount of investor capital inflow for all of 2007, which was a record US$194 billion.

So is it time to turn out the lights? Trying to shed some more clarity on the situation is US accountant Rothstein Kass, which published a report in early October entitled ‘On The Rise.’ It shed some revealing light on the situation at single family offices (SFOs), at least as it stood at the end of August, immediately prior to the Lehmans debacle. It found that nearly three quarters of SFOs currently invest in hedge funds and 60% were planning to increase their allocations in 2009. Seventy per cent of SFOs with hedge fund allocations said performance was in line with or better than expectations over the previous 12 months, although that was admitted before the wheels came off the investment banking bandwagon in September.

Adding to the data pool, Morningstar and Barron’s published a joint survey in November in which it was revealed that 63% of institutional investors think alternatives, led by hedge funds, will become more important than equities, bonds or mutual funds between now and 2013. A quarter of investors said they might increase their allocation to hedge funds over the next five years as they sought to diversify their portfolios. Interestingly, it was those old bugbears, lack of liquidity and transparency, that reared their ugly heads as potential obstacles to further investment.

Another Morningstar poll uncovered that nearly half of financial advisers who work in the wealth management sector expect that hedge funds will become less important in the next five years. While this seems to be contradicting the Morningstar/Barron’s poll, it illustrates what might well be the most important dynamic driving hedge fund investment (and redemptions) in the next 12 months. For years commentators (including this journal) have been observing the switch in emphasis within the hedge fund industry from the wealth management and private banking industries to institutional investment.

The current crisis seems to have exacerbated this and the two surveys above starkly illustrate how those traditional hedge fund investors, the private wealth advisors and private banks, are expecting to cut back on hedge fund allocations going forwards, while institutional investors plan to raise their investment levels.

“Institutional investors now account for a significant and growing percentage of investment in the hedge fund industry,” says Alexander Ineichen, Senior Investment Officer at UBS Global Asset Management, who authored a guide to hedge funds for institutional investors, published by AIMA recently. “While diversified hedge fund portfolios have comfortably out-performed most balanced, long only equity/bond portfolios this decade so far, the perception of investing in hedge funds is still often negative…the quantity of hedge fund bashing is plentiful while the dissemination of high quality hedge fund research is not.”

Ewen Cameron Watt, Portfolio Manager of the Diversified Alternatives Strategy at BlackRock, echoes Ineichen in arguing for the ongoing diversification benefits of hedge funds, regardless of performance and perception problems occurring at the moment. “Institutional investors should not be deterred from investing in alternative assets by the extreme volatility of recent times,” he says. “Alternatives are still valuable long-term diversifiers of equity and bond risk. Whilst some alternatives managers are challenged by redemption and de-leveraging dynamics, many areas are throwing up extreme value opportunities, which in the hands of skilled managers should deliver excellent returns over time.”

Out with the old rulebook…
We are still a couple of months away from the inauguration of a new administration in the US, but the auguries are not good for hedge funds. There are no indications whatsoever that the Obama administration will go easy on alternative investment firms and if Wall Street receives any support from Washington DC next year, the likelihood is that this will be grudgingly given and only because the alternative is worse.

Over 98% of senior hedge fund managers think that the new administration will increase regulation of the industry, at least in the US, according to Rothstein Kass. An overwhelming majority also think that increased compliance costs will make the whole hedge fund business model harder to operate and 75% said they expected the overall impact of the Obama administration to be a negative one, although perhaps not leading directly to fund closures or reducing the number of new start-ups. So what’s the problem? “It’s a generally accepted behavioural concept that uncertainty creates negative emotions,” says Howard Altman, the Co-Managing Principal at Rothstein Kass in New York. “The financial services industry in particular has always been leery of the unknown, as uncertainty magnifies risk. Consequently, we expected our findings to show a degree of scepticism regarding the new administration and its regulatory agenda. The election’s focus on the economy left many with the impression that regulatory reform will be a priority for the new regime. While the scope of these efforts is not yet defined, it is apparent that the hedge fund industry believes that regulatory action is on the horizon.”

Having said that, Altman argues that the hedge fund industry is still well-positioned to meet the demands of increased compliance. Only 7% of respondents to his survey said they thought increased compliance costs will make it more expensive to invest in hedge funds.

On top of this, the G20 countries seem to have recognised that more international action will be required if progress is to be made towards stabilising financial markets, and ensuring they will be robust going forwards. Following the summit meeting in Washington DC on 15/16 November, the G20 has clearly identified that more will need to be done in a number of areas over the coming months in order to bring a degree of stability to the global financial system. Some of this is bound to impact hedge funds. It will be the coordinated actions of these finance ministers which will provide the groundwork for a new era in financial markets.

Time for frank disclosure
The level of transparency and robustness of the OTC derivatives market looks set to change. Supervisors and regulators are also being asked to speed efforts to reduce the systemic risks of CDS and OTC transactions, as well as insisting that market participants support exchange traded or electronic platforms for CDS contracts. Regulators are also being asked to address the infrastructure issues within the OTC market and the relative transparency prevailing therein. This was something touched on by Griffin, Citadel’s founder, and Harbinger’s P Falcone, in their testimonies before Congress on 13 November, where they stressed that some kind of central clearing facility, for the CDS market in particular, was critical for the removal of much of the systemic risk currently presented by the OTC market. In addition, the G20 has said that “private sector bodies that have already developed best practices for private pools of capital and/or hedge funds should bring forward proposals for a set of unified best practices. Finance ministers should assess the adequacy of those proposals, drawing upon the analysis of regulators, the expanded FSF [Financial Stability Forum], and other relevant bodies.”

More disclosure is likely to be required of all financial institutions, including hedge funds. This will include risk disclosure, and the reporting of losses on an ongoing basis, consistent with internal best practice. Regulators will be tasked with ensuring that firms’ financial statements are “a complete, accurate, and timely picture of the firm’s activities – including off-balance sheet activities, and are reported on a consistent and regular basis.” Hedge fund managers, like banks, will no doubt have to get used to a new environment of greater disclosure of their positions. Major funds of funds have been pushing for more transparency for some time now but it looks like they will soon have the regulator in their corner as well.

Co-ordination from the top down
The other immediately noticeable theme amongst the statements coming out of Washington DC is the commitment to a higher level of standardisation and coordination amongst regulators and financial ministries. Consistency is the watchword here. This will include not only every G20 nation submitting its regulatory system to a transparent, independent assessment, but also a global review of financial regulation “with special emphasis on institutions, instruments, and markets that are currently unregulated.” Speaking on UK radio in October, Dominique Strauss-Kahn, Managing Director of the International Monetary Fund, said “stricter rules to control the market are essential,” and agreed that the need for a global regulator to ensure standards are being maintained was essential.

Finally, mention was also made at the recent Washington summit about the way financial institutions have been very short-termist in their remuneration of their employees. The G20 has taken the view that this has promoted an unacceptably high culture of risk within financial firms, and that this must be addressed as a matter of urgency. It is entirely likely that this will mean some form of formalised process of remuneration is encouraged within the financial sector that both banks and shareholders and other regulated entities can sign up to.

Even Soros, testifying to the House of Representatives’ Committee on Oversight and Government Reform, accepted that something radical was going to be needed to address the balance in the field of regulation. He told Congress that it was the responsibility of regulators to control the asset bubbles that crop up in markets, that markets in themselves cannot be trusted to reflect underlying economic fundamentals accurately and indeed can have a negative impact on the underlying economy itself. He called for higher controls over credit beyond basic money supply restrictions, something which could be achieved by “reactivating policy instruments which have fallen into disuse.”

“Clearly hedge funds use leverage and they contribute to market instability in times like the present when we are experiencing wholesale and disorderly deleveraging,” Soros said in his testimony. “Therefore, the systemic risks need to be recognised and more closely monitored than they have been until now. Appropriate regulations need to be devised. But we must beware of going overboard with regulation. Excessive deregulation has inflicted enormous losses on the general public and there is a real danger that the pendulum will swing too far the other way. That would be unfortunate because regulations are liable to be even more deficient than the market mechanism itself. That is because regulators are not only human, but also bureaucratic and susceptible to political influences.”

Fires fought in grim silence
The culture of silence at many of the largest hedge fund firms prevails, however, although the suspicion now is that they are too busy fighting fires within their own portfolios to worry about speaking to the media, or about what the man on the street thinks about them. The real concern, today, is staying in business through Christmas, as performance figures continue to demonstrate just how bad it is out there.

The RBC Hedge 250 index reported a net loss of 5.4% for October, not as bad as September (finalised at -8.05%), but still leaving the funds tracked by the index down 18.2% YTD. Big losers included convertible arbitrage, down 34.05% YTD and now avoided like the plague by funds of funds, and multi-strategy, which haemorrhaged 29.87% YTD. Tactically-based strategies, like macro, are still in positive territory, down just over 5% YTD, while managed futures looks like the stand-out strategy to be invested in, up 11.09% YTD, and 48%, yes 48% for the year so far. Never before has there been such a high degree of divergence between strategies tracked by the major hedge fund index providers.

“People had been expecting some sort of correction in the market this year, but they did not expect the destruction in value and the forced selling that we have seen,” says Neill Ebers, COO at Lionhart Investments. “Hedge funds are deleveraging, and selling to meet redemptions or cover margins. Funds of funds are seeing leverage products pulled…If you look at the statistical data, the market is operating in an illogical fashion. Some companies out there are trading through their cash terms. Hedge funds are selling the most liquid instruments, and some very good companies are seeing their value destroyed.”

A good example is the global resources sector, where several major hedge funds acquired substantial leverage in order to turbo-charge expected gains in resources stocks on the back of rising commodities prices. Now that most commodities are in free-fall, resources have been hammered, and several big names in hedge fund management are being forced into selling their positions. This is destroying the liquidity in the market. Brad White, Portfolio Manager with Canada-based multi-strategy hedge fund Salida Capital, told investors last month that the Salida Multi Strategy Fund, which was up over 10% in the first half of this year, is now down over 62% to the end of October. Like many other hedge funds being hit in the resources squeeze, he has been positioning the fund in undervalued, highly liquid securities, with 85% of the fund’s portfolio in shares with a less than one day average trading volume.

Perhaps more worrying is the ongoing fall-out from the Lehman debacle. We may not have heard the last of this. The failure of Lehman Brothers, and the near-failure of Morgan Stanley and Goldman Sachs, has severely spooked both hedge fund managers and investors. It has driven hedge funds into seeking multi-prime relationships, including with many of the smaller or newer players in the prime broking business, who have seen the collapse of Bear Stearns and Lehman as an opportunity to break into the market. But prime brokers themselves, including the newcomers, are reviewing their counterparty risk to hedge funds, diversifying their credit exposure across more strategies and even firing some managers if they feel overweight in a particular strategy.

“There is a concern about credit risk and counterparty risk, a knee jerk reaction driven by the runs on Morgan Stanley and Goldman Sachs that has sent a shockwave through the investor community,” says Lionhart’s Ebers. “People had not been paying too much attention to their prime broker exposure going into this. Lehman Brothers has led a lot of [investors] to wise up to the fact that their operational due diligence on their hedge fund investments is important.”

But beyond all this, there is still a massive problem with the rehypothecation of assets held by Lehman Brothers on behalf of hedge funds and their clients. Many funds are finding that assets ostensibly held in the Cayman Islands on their behalf by Lehman Brothers Europe have ended up in the US, diverted there by the bank to meet Chapter 11 requirements. Although administrator PricewaterhouseCoopers is on the case, in its last report to managers it admitted it would still take a year or more to establish the ‘path’ to assets, and even longer to value them. Those portfolio managers hoping to get some idea of what their Lehman assets are worth may have to wait until 2010 to get a figure they can use in an NAV.

Not only that, but many hedge fund managers may be lumbered with an equivalent securities clause which will see them being compensated with equivalent assets to those lodged with Lehman, not the original stock. It is no wonder then that those commercial banks breaking into the hedge fund space that possess established custody networks are hoovering up new business from funds fleeing the traditional prime brokers. Switching to a custody bank should also allow funds to dump the dangerous rehypothecation agreements they have signed up to, as well as the custody carve-out clauses that now look simply irresponsible.

GLG is one of the very few hedge funds that has come clean on its exposure to Lehman. Lionhart had already placed Lehman on a watch list in 2007 due to its credit exposure and had exited from all its naturally traded positions with the ill-fated bank by May of this year. But others have remained ominously silent. “A large number of hedge funds out there have not come clean,” says Ebers. “I can understand why they haven’t: the legal situation is still unclear, for instance. They may get anything from 100 to zero at the end of the day. But anyone who has not come clean probably has a large exposure to Lehman, and may be struggling right now.”

Out with the old, in with the new
This all points to the likelihood that the hedge fund industry as we knew it will be irrevocably changed by the end of 2009. How could it not be? In a year which has seen the demise of two major investment banks that served the hedge fund community as prime brokers, and the humiliation of two more, those hedge funds once deemed the ‘masters of the universe’ must now try to assess the likely fall-out from the current crisis and how this will affect their ability to do business going forwards. “There is the temptation to just hand money back to our clients, and go sailing,” admitted one fund of funds manager, who, predictably, asked not to be named.