“Hedge Funds: future trends and challenges.”

I went to a crowded talk about hedge funds and their future role in the financial system. There were four speakers, industry insiders – this meeting was conducted under the Chatham House rule – although I didn’t feel anything said was particularly sensitive. I was there out of curiosity and a desire to understand more about hedge funds and what they actually do.

One of the problems the speakers identified was one of definition: just about any fund can label itself as a hedge fund. Wikipedia defines a hedge fund as “a private investment fund open to a limited range of investors that is permitted by regulators to undertake a wider range of activities than other investment funds and also pays a performance fee to its investment manager”. Hedge funds use a variety of alternative investing strategies, including borrowing money to invest, to increase returns for investors, and charge on that basis. The strategies using a variety of investment tools, including short selling (selling assets they don’t own in the expectation the price will fall and they can then buy the assets back more cheaply – pocketing the difference in price), as well as a wide range of markets. Most “retail” investment funds – such as unit trusts and open-ended investment companies – can neither borrow nor short sell – they are “long only” funds. (Interestingly, investments trusts – companies in which the number of shares in issue is fixed (ie “closed”) – can borrow, and some of the aspects of the crisis in split-capital investment trusts in the early 2000s is reminiscent of what has happened to hedge funds recently.)

Increased leverage greatly increases the risk of an investment – the underlying assets cannot absorb the full extent of any losses, just as was seen in more traditional, but highly leveraged, banks, leaving funds teetering precariously.

There has been a lot of negative publicity in the media – particularly around Bernard Madofff and his alleged $50bn fraud; part of this seems to be a kickback from the overly positive representation of hedge funds before the credit crunch: these were the guys who made billions for their clients, and made billions for themselves. There was a great deal of hubris amongst hedge fund managers – they thought they could do no wrong, and their complex strategies had been raking in money during the good years.

These traders created their own myths: they were seen as the high fliers – the masters of the universe – who could do no wrong. Investors piled in, wanting to believe these heroes – hoping the magic would rub off on them. One fund manager, who was apparently producing annual returns of 45%, was feted by Forbes as being a kind of superman – his brain wired differently, creating ideas faster than anyone else. On the other hand, though, if there are 10,000 fund managers, by chance one or two will produce exceptional returns: this managers funds subsequently collapsed as the markets turned down. The media ties into investors unconscious needs and desires by building up their fantasies – their dreams of irrational wealth.

One of the things that has gone wrong with hedge funds is that their credit dried up. Some of these funds were heavily leveraged – arbitrage funds (a specific trading strategy) were typically leveraged twenty times (that is, for $5 of clients’ money, the fund would borrow $100 from a bank to invest, presumably with the invested assets as security), and fixed income funds were typically leveraged fifty times. That is a lot of leverage: if things go as the managers thought, clients benefited greatly. But when the credit was switched off – which is what happened in the credit crunch – they found themselves having to sell into a falling market.

The credit crunch has created some exceptional conditions. Most proprietary trading models didn’t cover market falls of 10% in a day, reckoning they were so unlikely as to be irrelevant – and yet there were two such days in October 2008.

We were shown some figures though that suggested that hedge fund performance hadn’t been as bad as other funds: Hedge Funds Research indices showed falls last year of 18.3%, against c. 40% for the broader market – so they didn’t actually do too badly. The trading strategies of many banks were as opaque as those used by hedge funds – and these of course were fully regulated and supposed to have effective risk management processes.

Short selling creates strong emotions. Dick Fulds, the former of Lehman Brothers, the collapsed Wall Street investment bank, said

When I find a short-seller, I want to tear his heart out and eat it before his eyes while he’s still alive,

– hardly a measured approach. The ban on short selling of UK financial institutions didn’t significantly effect the rapid decrease in the value of banking shares – bank shares fell more after the start of the ban on short selling in September 2008 than before, the UK banks index losing nearly 50% of its value whilst the ban was in place.

Shorting can be beneficial: it enable price disclosure, increasing the efficiency of markets. But it can also be detrimental: three situations were discussed in which shorting of shares can significantly effect the market in a particular share:

  • predatory trading, where traders know or believe a holder of an asset is a forced seller: they short the shares knowing another party needs to sell, driving the price down and profiting from the sellers distress
  • manipulation around capital raising, for instance after a company announces a rights issue, forcing a repricing of the issue and allowing the shorter to lock in at the lock price, reducing the amount the company can raise and increasing the company’s cost of capital in the process
  • crowded exits, where shorters trade on the backs of other shorting activity, expecting the prices to fall further – an example of the herd-mentality, which could lead to financial distress for the shorted stock and a loss for the company’s shareholders.

The future of hedge funds is likely to be far more regulated. The industry is a young one, and the skills of both hedge fund managers and their regulators need to improve: fund managers haven’t been through a major recession of depression before, and their trading strategies and models hadn’t been tested under these conditions.

What the regulation will look like wasn’t really discussed. It is likely to be electronic – automated systems interrogating data to measure returns against the strategy, and thereby detect fraud or trading which isn’t actually part of the strategy (and hence would change the risk profile for investors).

The number of hedge funds will decline: there has been a flight of capital (strange, given the positive relative – but not absolute – returns), and this will cause the closure of funds. Those that use strategies without a natural hedge are most likely to close – they don’t offer much that investors can’t get from more traditional funds. What has been a $2 trillion business is likely to settle down at around $600 bn – less than a third of its pre-credit crunch size: that is a pretty sharp decline, but perhaps reflects investors’ reduced appetite for risk and the reduced value of the underlying assets (which must account for a decrease c. 40%).

Fees charged by hedge funds are likely to decrease. The fee structure has been based on absolute performance – and that hasn’t been happening.

Fundamentally, the view seemed to be caveat emptor: if returns look too good to be true, it probably is (and Madoff’s managed returns seemed to be very regular, neat and unlikely, given the underlying market returns). An increase in transparency and accurate due diligence and measurement of funds’ performance is likely to be a market response. Investors should only invest in what they understand, and not accept the latest fad out of fear of being seen as unsophisticated: the Madoff affair has shown how sophisticated investors can spectacularly get it wrong.

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