FINANCIAL TIMES MONDAY SEPTEMBER 1 2008
FTfm
Hedge fund
investors seek
shelter from
meltdown
Risk Management
Risk control
companies are
devising ways to
spot signals of
collapse, writes
Eric Uhlfelder
Can hedge fund investors
sidestep meltdowns?
Take the collapse of Bear
Stearns’ high-grade struc-
tured credit and structured
credit enhanced leverage
funds, which reportedly
invested primarily in triple
A-rated tranches of mort-
gage-backed securities. Their
managers hedged their risk
through credit default swaps
to produce a positive carry
trade, promising steady
monthly returns of 100-200
basis points with limited
downside.
A year after the enhanced
version was brought to mar-
ket, it turned out that the
managers were not suffi-
ciently hedged after all and
that both funds were more
highly leveraged than inves-
tors understood.
Managers had initially bor-
rowed against their original
capital base before then lev-
eraging up. This meant that
5 and 10 times leverage was
really 10 and 20 times. Unbe-
knownst to investors, a spe-
cial financing covenant with
Barclays made the British
bank the sole equity investor
in the enhanced fund, leav-
ing all other investors with
no actual ownership rights.
To cut a long story short,
when the market for mort-
gage backed securities froze
and there was no meaningful
security pricing, these funds
plummeted in value. Lever-
aging banks withdraw their
financing, and the funds
were dissolved.
This was no surprise to
some. According to
Jonathan Kanterman, man-
aging director at the fund of
funds group Stillwater Capi-
tal Partners with $925m
(£504m, €626m) under man-
agement, “ given the funds’
significant leverage and
underlying assets, it
wouldn’t have taken much
of a decline in valuation to
wipe out all investor
capital.”
Olivier le Marois, chief
executive of Paris-based
Riskdata, a provider of soft-
ware solutions that helps
asset managers and hedge
funds control risk, says that
given the potential illiquid-
ity of Bear Stearns’ assets,
the funds’ steady returns
could have raised a red flag.
The reason: in a Riskdata
study of 3,216 hedge funds
and funds of hedge funds, he
found that nearly one-third
of funds trading illiquid
securities may be smoothing
their returns, which could
mislead investors about
actual underlying turbu-
lence.
Riskdata helps 150 clients
with assets of more than
$500bn avoid such melt-
downs by forecasting the
impact of hundreds of sce-
narios on funds for both
institutional hedge fund
investors and managers of
funds of hedge funds.
“We aren’t market fore-
casters,” says Mr le Marois,
“rather, we provide inves-
tors the tools to discern the
most likely outcome based
on their own projections by
combining factor- and
return-based modelling.” A
client may start with a basic
‘Running screens
can alert you to
problems you may
not have known
existed’
Meredith Jones
PerTrac chief
premise that US shares will
fall 10 per cent over the next
year. How then would this
affect a particular hedge
fund?
Relying on an extensive
database of historical co-
movements, Riskdata’s soft-
ware would suggest how
such a market decline might
affect other key variables
such as inflation, interest
and exchange rates, yield
and credit spreads, real
estate values, and spreads
between small- and large-cap
equities.
Then by laying these his-
torical data over a hedge
fund’s long-term perform-
ance, Riskdata projects the
likelihood of various out-
comes for the fund. Its soft-
ware tries to identify vulner-
abilities and possible
solutions.
But to help discern poten-
tial risk, Riskdata will meas-
ure key variables going back
before the fund’s own his-
tory began. For example, Mr
le Marois cites a US fixed
11
past. And he urges review of
risk management policies
and the experience of the
chief risk officer.
In addition to the stability
of its capital base, Mr Kan-
terman of Stillwater Capital
Management also assesses
how professionally a firm is
run. Transparency is critical.
Does performance consist-
ently correlate with strategy,
or does it suggest that the
fund has exposure in unex-
pected places?
But to Mr Kanterman, the
most persistent risk in
today’s environment is
marking assets to market.
Lack of liquidity and fair
pricing can drive down the
performance of a fund when
a few panic-induced transac-
tions become the benchmark
on which valuations are
based. “When you have
extreme swings in asset pric-
ing that occurs irrespective
of the asset value,” says Mr
Kanterman, “then one needs
to be extremely cautious of
leveraged hedge positions
because lending covenants
could easily be breached and
David Lyttleton loan facilities pulled on
short notice.”
income fund that started up may not have otherwise ommends investors review a Ultimately, most industry
in June 2005. Over the fol- known existed”. But she fund manager’s track record observers agree that quanti-
lowing three years, it gener- adds that these findings running different funds. He tative analysis can enhance
ated average monthly per- need to be further assessed warns that projections based transparency. But its find-
formance of 80 basis points, in a qualitative review. on historical review could be ings should be qualitatively
monthly volatility of 0.4 per Jiro Okochi, chief execu- misleading if a manager’s filtered to know their true
cent, and the worst monthly tive of Reval, a risk manage- current strategy and portfo- meaning and to help avoid
drawdown of -0.66 per cent. ment solutions provider, rec- lio has deviated from the false reads.
How could an investor
have foreseen that the fund
was to collapse 28 per cent
between July 2007 through
March 2008, with the biggest
single monthly decline being
nearly 14 times worse than
the fund’s previous poorest
monthly performance?
When credit spreads
between one-year and
10-year Treasuries widened
by 22 basis points [the larg-
est increase during the life
of the fund], Mr le Marois
found the fund’s return
dropped 1.7 per cent below
its average performance.
When spreads narrowed by
the same amount, the per-
formance increased 12 basis
points over its norm.
Given that spreads
declined an average of 7
basis points during the life
of the fund, historical per-
formance would suggest lim-
ited downside risk.
But by looking at spread
histories going back to 1987,
Riskdata found the worst
spread widening was 96
basis points, which occurred
just a year before the fund
opened. This suggested far
greater risk than historical
return analysis would have
indicated.
In February 2008, credit
spreads widened by 98 basis
points, sending the fund
lower by 9 per cent.
Meredith Jones, managing
director of PerTrac, maker of
asset allocation and invest-
ment analysis software used
by more than 1,700 clients
across 50 countries, believes
that “running screens on a
regular and ongoing basis
can alert you to problems
and probabilities that you