"The hedge fund industry is still under pressure, but it has qualities which will ensure that it survives one way or another. However, no one is in any doubt that there will be a contraction of the business at least over the rest of the year," the report said.
"The question is: how soon is it safe to invest again? At the risk of being glib: the answer is: as soon as investors stop putting in redemptions. Because then the selling pressure will be over, and hedge fund managers can stop scraping around for liquidity, and get on with finding anomalies to arbitrage and other efficiencies to profit from."
Christopher Miller, Allenbridge HedgeInfo’s CEO and author of the report, writes: "In future, greater diligence will definitely be required at all levels, and we are sure that some investors will be shy of hedge funds for a long time. That is probably not a bad thing, as hedge funds remain a specialist investment product."
The report also illustrates the mechanics of a typical bubble – see below.
We spoke to Christopher Miller, and started by asking him what point he thought we were in the bubble.
A: "I think it is safe to say we are somewhere on the downward slope. I would be a liar if I said I knew where we were on the downward slope because there are a lot of variables left. There are two sides to this; which bubble are you talking about.
"There are two bubbles that we could be looking at, one is the hedge fund bubble i.e. there was a lot of money going into hedge funds which has propped up some of their strategies and the money coming out overwhelms the strategies and makes them perform more poorly.
"The other is the global market bubble which I think was credit driven and is still extremely stressed. I think there is a chance of us coming out of the hedge fund one first. That is interesting for hedge fund investments because if the funds are not scratching around for liquidity they can actually make money in rising or falling markets. If the liquidity improves because there is less money being extracted from hedge fund strategies then there is a better chance of them performing better."
Q: When do you think liquidity will become less of an issue?
A: "I think towards the end of this year. By the end of the year everyone who wants to redeem will have put in their redemptions and hopefully there will be some stabilisation in the currency markets because those are the two key factors which have been knocking hedge funds. A lot of hedge funds with hedged currency classes for example have to sell their dollar denominated investments in order to meet their margin calls on their hedging. That is a major force. I think that will probably unwind mainly in the near term but up till the end of the year assuming the currency stabilises.
"For example I was talking with one manager recently whose hedging does not require margining and their next valued date is 31 December. I think they are very lucky because it is relatively rare because banks are now demanding margin where previously they were happy with the credit lines that were given to currency traders, be they for hedging purposes, investment or trading purposes. They were previously happy in the knowledge that their were assets there. Now they are demanding cash margin of say five per cent, which is quite a major difference.
"In addition, if the underlying positions themselves the currency forwards are in loss to the tune of 20 per cent in those currency classes they are going to have to sell 15 to 20 per cent of the underlying assets. That is pretty tough. Some of that will be happening as we go on a mark to market basis, and will have happened already and put hedge funds under a lot of stress. Some of it will happening as the rest of the year unfolds, assuming that there are no other changes in the currency markets.
"In terms of redemptions, what we have seen is that managers do not really know for sure how much is going to be redeemed. They know that they have received a certain amount of redemption notices, and they are assuming that some of these notices may or may not be executed when the time comes. Clients may change their minds when the time comes.
"Managers hate that because it plays havoc with their liquidity situation but the fact is if they are asked by their clients to keep the money in at the end of December the chances are they will all say yes. They really dislike that free option on the part of the client but equally the clients would be mad not to give themselves that option. The redemptions are trickling down to the underlying managers where for example a hedge fund of funds investor is putting in a redemption notice with the fund of funds. I think we are seeing a lot of that.
"The fund of funds is therefore putting in redemptions with the underlying sub managers as you can imagine. The underlying sub managers are variously saying 'well, ok you can have the money', or they are saying 'our underlying investments are not liquid enough to extract this much of redemptions, therefore we are going to invoke our gate or we are going to suspend redemptions,' and the hedge fund of funds is left carrying the can, and thus the underlying investor is not very happy.
"There has been a lot of talk about this recently and investors have been very unhappy with the way they think they have been treated. Our opinion on that sort of situation is that where for example a fund of funds has very little choice, in other words its underlying assets are becoming liquidity impaired. If they have that situation and there is nothing they can do about it then it is wrong of them to redeem the funds that they can and hand those out to the investors that want to get out, because it has to be correct for the investments to be redeemed on a pro rata basis. That is why some of them are putting investments into side pockets.
"It is not a popular thing but we believe it is the least bad way of approaching a difficult situation. Now why are these sub-managers deciding they are not going to allow redemptions? It varies – in some situations there is generally illiquidity and perhaps they promised more liquidity than they were able to deliver. That is a very common theme, and not necessarily a bad one.
"But there are sub managers who have said to themselves: ‘The investors are treating us like cashpoints. They are indiscriminately pulling out money. Our strategy is good. There is no reason for them to be pulling money out. I don’t want to lose my management and performance fees so I am going to tell my directors to put a suspension of redemptions.’ I can’t name any names but there have been allegations of that sort of behaviour happening."
Q: In the report you said ‘the question is: how soon is it safe to invest again? At the risk of being glib: the answer is: as soon as investors stop putting in redemptions.’
A: "I think what I am saying there is that there is no easy answer to that. Predictions are notoriously unreliable especially ones about the future. It is impossible to say when it is going to alleviate but the signs are good so far. The word I’ve had back so far month to date [mid-November] is that many managers are cautiously optimistic. I don’t think they are singing and dancing about it but the pressure seems to be alleviating.
Q: You said the word you are hearing so what is that based on?
A: "That is based on a couple of fund of fund managers I have spoken to in the last couple of days. The main report relates to a much larger amount of UK, European and US managers who I have spoken to over the last months.
"Last week for example I was speaking at a US risk management conference where I was able to exchange views with industry peers."
Q: Do you think the case for hedge funds has been undermined by recent events?
A: "No I don’t think it has been undermined. The larger and better informed investors are actually increasing their allocations to hedge funds wherever they can, and that is quite simply because their investment portfolio of hedge funds will have been performing better.
"Now the fact that hedge funds haven’t done what they say they will do on the tin, which was that they can make profits whether markets are going up or down, is annoying to many investors but – when I say they haven’t done what they say will do on the tin, they don’t promise anything. Hedge funds are very careful not to promise anything, but they do say that they can make profits whether the markets are going up or down, so to that extent there is disappointment but they have not misled anyone.
"The fact remains that although hedge fund returns have been disappointing many people have positioned themselves for a rough ride with hedge funds that they thought would make money in a downturn. All they have done is lost less money than in the mainstream investment market, and being pragmatic about it losing less money than all investments which seem to be correlating to one, is a good thing. Barring Government bonds there are few investments out there that have performed as well as hedge funds."
Q: Do you think the short selling bans have aggravated the problems for hedge funds?
A: "I think the perception has aggravated the problem. Short selling is something that has been around for quite a long time. Hedge funds are often demonised for their short selling activities, whereas in fact a lot of their short selling is not in any way elusive. It is actually beneficial, because for example when they put together an arbitrage trade involving a long and a short that increases market efficiency. There is no other way of looking at it.
"The scaremongers tend to pick on the negative side of hedge fund investing. They will claim that hedge funds were trying to ruin Volkswagen, when in fact the majority of hedge fund investors were simply doing an arbitrage trade between preference shares and the ordinary shares. I think that is a very typical response from the mainstream press, which is to pick on the negative side without wanting to show the beneficial side of hedge funds.
"Where does that come from? I think firstly that some hedge fund managers are reputed to make a lot of money. It is by no means all of them, and the way advertising money flows most newspapers have very little to lose by saying negative things about hedge funds and positive things about long only managers. The mainstream press has not had much contact with hedge fund managers. They are reputed to be secretive – partly that is because some of them are but also because they are not allowed to talk to the press. I think the press has misconceptions of hedge funds out of lack of contact really. What we try to do is increase contact, increase information and provide a balanced view."
Christopher Miller, CEO, Allenbridge HedgeInfo
Q: Which strategies do you think will be successful given that you are anticipating redemptions stopping and hedge funds will then be able to start performing again? Will there be any difference to the situation prior to the redemption demands?
A: "Leverage is obviously a major factor for hedge funds: that is not to suggest that all hedge funds need lots of leverage because on average they don't, and average leverage levels are quite low. When we are looking at long/short equity strategies, for example, a lot of the leverage comes from selling short effectively. Financing is tighter – the availability to short is tighter and it reduces the opportunities available to hedge funds.
"Will that turn around? It is a question of confidence in the market, and the more the long only world holding large portfolios of blue chip equities are confident that the hedge funds are not going to go under the more they will be confident in lending out the stock. Certainly from a relaxation of confidence long short equity stands to benefit, and one of the worst categories is convertible arbitrage which has been very badly hit. It remains to be seen how quickly they will respond.
"Distressed strategies are becoming quite interesting. There is increased interest in distressed strategies, and people have been saying for the last year or so when do you invest in distressed, because no one could be quite sure when the recovery was happening. There is certainly a greater degree of interest whether we have had the final bottom in the conventional market - whether we have had enough panic to create that traditional bottom – I don’t know. There are commentators that suggest we aren’t finished yet. I have to sit on the fence on that one because I believe that there are reasons why we may not have finished yet, and there are reasons why we shouldn’t have finished yet.
"The global economy has woken up to the need for more risk management but is it on track to put in place adequate risk management across the global market? Frankly I think that unless we see some more action then the pubic is probably not ready for the increased regulation.
"A lot of what has been going on, such as the taking over of banks over the last few months would have been inconceivable, A year ago there would have been zero public acceptance of the need to take over a bank because the free market can just sort itself out, and it has taken crashes like this to make the public realise that these sort of things are necessary. It is a big departure to go to increased oversight and possible regulation. We are pro-oversight and less pro-regulation of hedge funds.
Q: The practicalities of how much regulation have not really been addressed have they?
A: "They have not. If you look at statements coming out of the European Commission they are anti-regulation. It remains to be seen what Charlie McCreevy says in his report, which is coming out in December, but he is anti-regulation and probably rightly so.
"At HedgeInfo we differentiate between oversight and regulation. I believe it is very important to get more information. Without that information there is no justification for regulation. There is no justification for intervention because some of these knee-jerk reactions that we have heard from certain European heads of state are uninformed, reactionary, incendiary statements which really don’t help anyone.
"I am referring to statements made in Italy and Germany about hedge funds. I think they don’t realise the benefits of hedge funds to even their economies, and they were in effect playing to the audience because the public believe what they read in the press. That is a very dangerous side of it but it does seem that Charlie McCreevy is taking a sensible approach.
"I personally believe that oversight means aggregating data across hedge funds, prime brokers, administrators, and jurisdictions. It is a huge job but I was amazed after LTCM folded it was blindingly clear that the real failure was in the inability to see what the overall exposure was of LTCM. The firm were not giving any single investment bank/prime broker full sight of its investment portfolio.
"We need a global agency to aggregate this data on an anonymous basis and be able to identify concentrations of risk within single hedge funds, within single investment banks. And I am not just talking about traditional leverage. I am talking about pro-actively looking for concentrations of risk that may not have been encountered before, and if the aggregated anonimised data is made semi-public then different countries can point a finger and different participants can point a finger and say something needs to be done.
"I don’t want to go too far down the line of what should or should not be done because it such a complicated operation but effectively prime brokers need to be able to spot the risk, not only to their portfolio but to the hedge fund that they are dealing with on an aggregate basis. For example they would need to share data with a hedge fund’s two other prime brokers.
"From a starting point of that we would need to chunk up to a higher level and say how much risk has this investment bank taken on, how much risk is their in this country, is it correct that the banking system in the UK got so much over-leveraged with so little collateral on its underlying loans? Is that right? The same questions could also be asked of the US.
"It has got to come from the top because the failings of the past came from the top. I am in no doubt about that at all. When you think about the heads of banks taking these extra risks – yes of course it is undesirable. But regulators exist because it is known that banking organisations will tend to take more risk than maybe good for the wider market. The regulators collectively failed to exercise due care and diligence with these banks, for example in 2003 the SEC removed the leverage limits for investment banks and promptly leverage went from around 12 times up to about 30 or 40 times. Does that sound prudent? I don’t think so.
"In the UK when the FSA had all those warnings about Northern Rock there was no political motivation to actually tackle it. One has got to remember that at the time in 2007 Gordon Brown made about 12 per cent of his fiscal revenues from the UK financial services sector, which is rather a lot. It would have been a poor career move for the FSA to have put a break on to some of the income from the growth of the financial services sector.
"I am not suggesting that there was any complicit behaviour or overt decision that that should be the case but when your paymaster effectively stands to lose such a large amount from that sort of activity one would naturally think twice. Gordon Brown would certainly have been aware of the increase in not only leverage but increase in lack of collateral behind that leverage, but in those days no one really thought that there was a risk. Although there were plenty of people telling the FSA and writing about the risks of leverage there were enough people who really believed that credit risk was no more.
"I appreciate it was a difficult call but ultimately the regulator and the government are there to make those difficult decisions, and if a government has discovered that it is able to override the business cycle by allowing leverage to increase beyond historical highs then one has got to question the prudence of it."
Q: What do hedge funds need to do now and when the market picks up?
A: "I think hedge funds need to keep a relatively low profile right now. We have spoken with some hedge funds who have some redemptions but have net inflows so it is not looking too gloomy, but obviously there are other hedge funds that have significant problems and some that are having to hive off half their whole portfolio into side pockets.
"The message is that there are opportunities in hedge funds but that extreme caution is required, and a greatly increased approach to due diligence more than ever before is necessary."
