12
FTfm
Hedge funds
scramble to
install damage
limitation
Risk management
The credit crisis
proved these
alternatives do not
work in periods of
illiquidity, writes
Eric Uhlfelder
Many hedge funds only
make money when stocks
are rising and economic
conditions are tranquil,
according to Roy Niederhof-
fer, who runs $1bn of hedge
fund money. “They often
fail to provide a hedge dur-
ing bear markets and peri-
ods of illiquidity,” says Mr
Niederhoffer.
As evidence, he points to
the Hedge Fund Research
Fund Weighted Composite
Index whose trailing three-
year monthly returns
through August were on
average 0.80 correlated to
the S&P 500. In contrast, Mr
Niederhoffer’s Diversified
Program was -0.55 corre-
lated with the broad market
over the same period.
In spite of the recovery in
the industry’s performance
this year to September, Mr
Niederhoffer’s point still
holds.
Year to date, the Barclay
Hedge Fund Index was up
19.80 per cent; the S&P 500
returned 19.26 per cent and
the S&P 1200 Global Index
soared 25.96 per cent. Only
three out of the industry’s
17 trading strategies outper-
Some success stories
Managers and investors
may be well served by
seeing how some of last
year’s successful funds
thrived, writes Eric
Uhlfelder.
James Melcher, founder
of Balestra Capital Partners,
thinks there were plenty of
signs that mandated a
move away from the bull
market group-think and
extreme risk-taking of the
previous four years.
Using active hedging and
avoiding crowded trades
help Balestra maintain a
highly flexible portfolio that
can shift positions quickly.
The fund limits individual
positions to no more than
2.5 per cent of the
portfolio. It can liquidate 90
per cent of the portfolio
formed the global index.
Hedge fund managers are
also perceived not to have a
particularly good handle on
managing risk. If that is the
case, then the idea of abso-
lute return, on which the
industry has been mar-
keted, is seriously
challenged.
“The dubious nature of
this claim is what many
investors have come to real-
ise in the aftermath of 2008
when the average fund lost
more than one-fifth of its
value,” observes Sol Waks-
man, founder of Barclay-
Hedge.
“The number of managers
who saw the crisis coming,
was precious few, and many
got hit hard because they
found themselves in strate-
gies that no longer worked
and liquidity had been
blocked.”
Investor distrust is seen
in the precipitous decline in
hedge fund assets. After
peaking at the end of 2007
at £2,140bn ($3,990bn,
€2,663bn) according to Bar-
clayHedge, assets then fell
by more than 40 per cent in
the following year, ending
2008 at $1,230bn. And
through the first half of
2009, they lost another 20
per cent, with assets having
fallen below $980bn.
Ron Papenek, head of
business strategy at Risk-
Metrics Group, an inde-
pendent financial risk con-
sultant, says: “Intense com-
petitiveness among hedge
fund managers to attract
investor capital drove many
within one hour. And
Melcher’s team has no
problem moving into large
cash positions, which hit 80
per cent in 2008.
His $1bn flagship global
macro Balestra Capital
Partners fund was up nearly
45.75 per cent in 2008. In
September, the fund’s
five-year compounded annual
return was 41.76 per cent.
David Gerstenhaber’s
Argonaut Capital, with
$550m under management,
maintains an asymmetric risk
profile, largely achieved
through the use of options,
which provide substantial
upside potential while limiting
the downside. He also cuts
risk when losses begin to
mount within a month,
starting at 2.5 per cent and
Safety net: managers are refining their approach to risk
to imprudently shift their
focus away from risk.” As a
result, the industry
rewarded managers who
took on excessive leverage
and exposure to riskier
assets over those who were
demonstrating greater
discretion.”
then by 4 per cent. By 7 per
cent, his funds go completely
neutral. He limits leverage by
asset class and applies
stress tests on a daily basis.
Last year, the Argonaut
Aggressive Global
Partnership fund gained
12.39 per cent, and in
September, his five-year
compounded annual return
was 15.4 per cent.
Roy Niederhoffer’s
investment approach is
based on very short-term
trades (lasting on average
between one to two days)
configured around historical
investor behaviour, which
together he believes
inherently controls risk.
He further controls risk by
relying on diversified trading
strategies, each scaled and
Getty
This propelled a vicious
cycle, exaggerated by the
freezing up of credit. To
meet redemptions, multi-
strategy funds were forced
to sell their most liquid
assets at particularly inop-
portune times, such as
those in long-short equity,
designed to enter and exit
positions at different levels.
“Each is influenced differently
by volatility, and they have
extremely different return
profiles,” says Mr
Niederhoffer, “so when a few
strategies are down, we want
others to be up.”
Mr Niederhoffer’s
Diversified Program soared
by 50.28 per cent in 2008.
His compounded annual
return over the past five
years through to this year’s
third quarter was 17.2 per
cent.
Institutions should also
consider specialised
managers whose returns may
be more predictable, such as
Stillwater Capital Partners,
which focuses on asset-based
lending. According to
FINANCIAL TIMES MONDAY OCTOBER 26 2009
Hedge fund strategies versus stocks
Strategies
Year-to-date
% returns*
Convertible Arbitrage index
Distressed Securities index
Emerging Markets index
Equity Long Bias index
Equity Long/Short index
Equity Market Neutral index
Equity Short Bias index
European Equities index
Event Driven index
Fixed Income Arbitrage index
Fund of Funds index
Global Macro index
Healthcare &
Biotechnology index
Merger Arbitrage index
Multi Strategy index
Pacific Rim Equities index
Technology index
Barclay Hedge Fund index
S&P 500 Total return index
S&P 1200 Global Total Return
Source: BarclayHedge
‘The number of
managers who saw
the crisis coming,
was precious few’
Sol Waksman
BarclayHedge
locking in losses. But it also
forced them to subse-
quently pull out assets from
less liquid, longer-term
strategies, such as dis-
tressed credit and event
driven – accelerating their
own decline – to redistrib-
ute risk.
“Virtually overnight,”
says Christopher Ito, head
of portfolio risk manage-
ment at Union Bancaire
Privée in New York, “osten-
sibly uncorrelated strate-
gies and asset classes began
tracking similar perform-
ance, amplifying losses,
abruptly leading to the col-
lapse of portfolio diversifi-
cation and the sense that
risk was being managed.”
A monumental scandal
made investors wonder how
Jonathan Kanterman,
managing director of the
firm’s billion-dollar portfolio,
the key is in thoroughly
understanding the various
industries to which the
funds lend.
Stillwater relies on
in-house and third-party
experts to accurately value
collateral that backs all
loans. Having enforceable,
unencumbered clean title to
such collateral is also
essential.
The firm also avoids
unnecessary leverage.
The Stillwater Asset
Backed Fund was up 9.8
per cent in 2008. It has
returned an average of
approximately 8 per cent
over the past five years as
of August.
Performance
relative to
S&P 1200 Global
47.08 +
26.05 +
36.94 +
-
23.73
12.44 -
0.63 -
-15.58 -
16.75 -
25.03 -
10.04 -
8.13 -
7.42 -
23.46 -
9.46 -
23.00 -
12.85 -
17.19 -
19.80 -
19.26
25.95
* To September
much due diligence hedge
funds were really practising
and how much of their fees
were really being spent on
protecting their assets.
Then they discovered how
locked up their investments
can be.
In its March 2009 annual
survey of alternative invest-
ments, Deutsche Bank
found that “never before
had we seen such a raft of
managers invoking gates,
suspending redemptions
and increasing sidepockets
along with numerous other
means to dissuade and
prevent investors from
redeeming”.
Moreover, the report
found that “liquidity mis-
match, that had long been
recognised in the industry
as potentially damaging,
finally came to the fore”.
“Transparency, risk man-
agement, and liquidity are
now top priorities for inves-
tors as they select their
hedge fund managers,” said
Jonathan Hitchon, co-head
of global prime finance at
Deutsche Bank, “and as a
result, we have seen manag-
ers of various strategies
adjust their structures
accordingly.”
Many hedge fund manag-
ers are refining their
approach to risk. According
to Tim Garry, chief risk
officer at Passport Capital
with $2.1bn in assets, whose
global flagship fund was
down 51 per cent last year,
“we didn’t rely on any spe-
cific downside constraints,
such as stops that would
kick in when market losses
begin to mount, because we
believed the fund’s long-
short composition is
designed to contain such
downside risk”.
The current crisis has
produced fundamental
changes in the way his firm
defines and manages risk,
aggregating it from each
individual investment and
sector into a quantifiable
entity.