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Hedge fund crisis?

Hedge funds ought to thrive in a financial crisis. It is when market inefficiencies, dislocations and mispricings are at their greatest. The subprime, leveraged loan and structured credit problems are demonstrating the differences between good managers and many unskilled "hedge funds" that simply took on unhedged credit risk and collected illiquidity premiums. Long volatility strategies are really the only products likely to profit from market turbulence except perhaps short biased and "risk free" government bonds.

It's important when picking investment styles to differentiate between skill-based and risk-premium based strategies. Funds dependent on positive carry credit spreads can't be considered hedge funds. Many forms of credit and fixed-income arbitrage rely on such phenomena. The yen carry or positive yield curve trades are examples. Similarly with equities only a fraction of long/short stockpicking "hedge funds" actually are hedge funds. Many just play the risk premium often exhibited by such securities in bull markets.

Most public domain arbitrage strategies with a short volatility profile run into problems sometimes especially if leverage and illiquidity are involved. Two years ago we had a CB arb crisis and now we have a subprime led crisis hurting a few beta bandits and helping the alpha dogs. Both situations offered money making opportunities to those managers with the capability to exploit them. Alpha is zero sum so the ONLY way to produce alpha is for other market participants to lose money.

A core strength of the alternative investment industry is performance dispersion. With traditional funds if their benchmark is down, it is likely they are also down. With hedge funds the winners use their abilities and experience to extract money from the losers. It is unfortunate some investor capital has been lost through unjustified confidence in sub-prime linked credit products. This just confirms the need to identify proper hedge funds and even then put in only a small proportion of capital. For many investors that means quality funds of funds will probably be the best entry point. The 80/20 rule tends to apply here; only 20% of hedge funds are any good and only 20% of funds of hedge funds are good at identifying those underlying funds.

In optimizing portfolio construction for alternative investments, I have usually found the maximum an investor should have in any one fund is 5% and therefore 95% in unrelated, independent strategies. Even if one accepts naive credit carry as a legitimate "hedge fund" strategy (which I do not), the most any investor would have lost from these CDO-linked meltdowns would be 5% of their TOTAL alternatives portfolio. If they have spread their bets properly they will also have money with other funds that benefit from the dislocation. That is the reason EVERY investor should allocate to short-biased equity and credit funds; even if the returns have been poor (so far!) the critical importance of negatively correlated strategies to managing portfolio risk should not be underestimated.

Most good hedge funds use quite low leverage, if at all. It is true weaker alternative investment products employing high leverage may blow up which is why due diligence is so important in determining that expertise and robust risk management are evident. Rare event risk and massive losses are hardly confined to incompetent "hedge funds". Pets.com, Worldcom and Enron and thousands of other equities lost all their shareholders' capital but that does not mean people should avoid ALL stocks just because some drop 100%. Hundreds of dotcoms imploded a few years back losing several hundred billion for investors but Ebay, Amazon and Google and many others have performed well. Good hedge funds aren't going away any more than good stocks. The bear market of 1973/74 blew up dozens of long biased beta dependent "hedge funds" while managers like George Soros, Michael Steinhardt and others thrived.

As a value investor I value strategies able to achieve consistent absolute returns at low risk. I think investors should be compensated for risk. When I look at a hedge fund I am looking for a margin of safety - performance should be much higher than the risk. Volatility is NOT risk but it is a useful first cut. Over time the S&P 500 has generated about 8% annually at 15% standard deviation so its returns have been derisory compensation for its risk. Most other equity indices and long only funds offer an even worse value proposition. Investors are better off with products that give DOUBLE digit returns at SINGLE digit risk. 10%-14% a year at 5%-7% sigma is AVAILABLE if you do your homework. 30% a year at 15% vol is also fine but definitely NOT the other way around. Which is common sense - low risk, high return or high risk, low return?

Ideally performance is generated from securities that are liquid and frequently valued. Funds straying into illiquidity need to provide compensation for taking on that much less manageable exposure. Often it is weaker funds that wander into the minefield of assets that hardly ever trade. The analysis get more complicated when a strategy is taking rare event or assumption risk. Several of the recent blow ups gave the appearance of low volatility due to investing in rarely traded, mark to model instruments. If there is a lot of leverage involved you have to look at whether the returns compensate for that gearing and valuation risk.

It is not in the nature of proper hedge funds to blow up, it is the nature of those who have useless trading models, incorrect assumptions, don't understand complex strategies or rigorous risk management to blow up. It all comes down to experience in actually trading the strategies and due diligence in identifying whether the targeted returns are sufficiently high from the risks being taken. For illiquid, mark to model funds, 1% a month was woefully below the required return for any margin of safety in such hazardous credit strategies.

I am typing this watching the British Open golf championship. The subprime crisis is a Carnoustie effect; defined as "that degree of mental and psychic shock experienced on collision with reality by those whose expectations are founded on false assumptions." Sounds familiar with the current subprime CDO crisis giving a classic reality check. A question to ask investment managers claiming to run a hedge fund, "What exposure does your strategy have to the Car-Nasty effect?". If the strategy assumes sunny market conditions and normal distribution fairways, walk away.

There are other parallels between finance and golf. While everyone recognizes there are skilled golfers able to negotiate "random" Scottish weather some deluded souls continue to doubt the existence of skilled fund managers able to negotiate "efficiently" priced markets. Such skill MUST be in limited supply. Of all the people who have ever swung a sand wedge, few would be justified in calling themselves "golfers". Much fewer deserve to be considered "world class golfers". Similarly only a small proportion of "hedge funds" actually are hedge funds and fewer still are world class hedge funds.

Can you imagine the average score at the Open if everyone who said they are a "golfer" played? The media sports pages focus on the stars while the financial pages focus on the losers. When academics study hedge funds they try to study EVERY product that says it is a hedge fund and bothers to report to some database. Hedge fund indices and "investable" hedge fund index funds are an even sillier idea than stock or bond index funds. The indexers would have you believe every large open hedge fund is worth investing in! Even most legitimate hedge funds are avoids, let alone all the impostors and risk premium players.

Lending to the US government at 5% is not a bad bet but seeking a higher yield from slicing and dicing sub-prime mortgages into allegedly bankruptcy-remote vehicles was not. Despite some tranches being highly "rated" they always traded far wider than proper straight debt with the same rating. Some investors place too much reliance on "independent" agency opinions. Debt ratings are paid for by the issuer and most equity "ratings" are purchased by promises of investment banking business. Proper fund managers pay little attention to what analysts think of a security and are sceptical of ratings agencies. Just because Moody's or Standard and Poor's say something is AAA does not mean it is. There was nothing "High Grade" about those subprime mortgage concoctions, ever, for the simple reason that the modeling assumptions were clearly dubious ahead of time.

It was absurd to assign a measure originally designed for rock solid government and corporate debt to the untested, till now(!), financial alchemy of LSS, CDO, CLO, SIV and CPDO. It is applying a fundamental balance-sheet metric to model-based credit structuring using wildly optimistic assumptions of default and recovery rates and correlations of different borrowers. Collateral is "sound" only if someone else will buy it at prices you assume. Asset-backed securities ratings depend on realistic, frequent valuations of those underlying assets.

Subprime started impacting the markets 6 months ago. If product structurers want to rate shop for a sellable classification that is their freedom but investors should not rely on them. The only bonds "investment grade" are those assets whose future possible rewards compensate for the future possible risks. How shortsighted to gain a few hundred basis points for a while but end up losing 5,000-10,000 basis points.

Just because MSCI, FTSE, Nikkei or any other benchmark providers makes the active decision to place a stock in their "passive" index does not mean it is any good. If a broker's stock analysts say something is a "strong buy" that does not mean you should not short it. The "ratings" put out by various firms on hedge funds and used in hedge fund "index" construction are even less reliable. I have seen industry awards given to "top" hedge funds that weren't even hedge funds and some that imploded soon afterwards.

It all comes down to doing your homework backed up by due diligence and advice from those who truly understand alternative investment strategies. And diversifying sufficiently so that possible negative performance of any one fund or strategy does not have a debilitating effect on your portfolio. Twenty hedge funds managing different strategies that have little correlation to each other is probably the MINIMUM number necessary.

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