Fund of funds model called into question

The credit crunch has brought the rude realisation that hedge funds (most of them anyway) do not exactly triumph in adverse market conditions. Nevertheless, hedge funds can thank the impact of previous negative events for putting them on the radar of investors around the world. For it is widely acknowledged that the blow-up of US hedge fund Long-Term Capital Management in the wake of the 1998 Russian financial crisis coupled with the dotcom crash of 2000 served to spark investment in hedge fund strategies as alternative sources of return. The vehicle of choice Much of the new money earmarked for hedge funds flowed into fund of funds. Assets under management in funds of hedge funds increased from $83.5bn (E61.2bn) in 2000 to a high of $825.8bn in the second quarter of 2008 before client capital redemptions caused a retreat to $593bn at the end of 2008, according to data-providers Hedge Fund Research (HFR). The number of funds of hedge funds also rose sharply from 538 in 2000 to 2462 in 2007. A record number of liquidations saw that total fall back to 2368 at the end of last year. As the number of funds of hedge funds increased, so did the level of leverage applied. An underlying hedge fund manager running an equity long-short strategy might be 1.5 to 2 times levered with the fund of hedge funds manager applying an additional 1 to 2 times of leverage. “Equity long-short funds represented the largest number of hedge funds around and they posted reasonable performance beyond the Bear Stearns hedge fund blow-up,” says David Butler, a consultant at hedge fund advisers, Kinetic Partners. “Issues arose for them in 2008, when they had to lower their leverage and markets started to tumble and investors pulled out. It was just a leverage game falling apart at the seams,” he adds. But that leverage game fuelled some stellar performance in strategies such as equity long-short, convertible bond arbitrage, merger arbitrage and distressed debt, notably in 2003 and 2006. As money continued to flow into hedge funds, it became difficult for investors to gain entry to popular strategies as managers imposed capacity limits. This situation existed right up to September 2008 when the Lehman Brothers collapse sparked a rush of capital redemptions. “We had 30 per cent redemptions in the second half of the year which seemed to be about average for the industry,” recalls Derek Stewart, a director of Mellon Global Alternative Investments (MGAI) which runs $750m of fund of hedge fund assets in mainly credit strategies and is a subsidiary company of BNY Mellon Asset Management. “The problem was that if all the hedge fund managers were being hit by 30 per cent redemptions at the same time, you couldn’t physically raise the cash to meet those redemptions because the credit markets had stopped working,” he explains. “The managers that were forced to sell potentially went out of business. The managers that raised gates managed to navigate through the difficulties and survive, restructure and are still in business today.” Short notice Kinetic Partners’ Mr Butler contends that funds of funds have exacerbated the liquidity problem for the hedge fund industry by offering easy redemption terms to investors, allowing them to cash out at a month’s notice. “The huge amount of redemptions are being caused by the intermediaries falling apart and having to redeem and the mismatch between the longer-term view that hedge funds need [to make money] for their investors and the easy redemption facilities that are available through the funds of funds.” Christopher Fawcett, CEO of $5.4bn fund of hedge funds manager, Fauchier Partners, a subsidiary of BNP Paribas Investment Partners, says the need to hedge dollar-denominated assets into sterling and euros forced the firm to redeem large amounts from underlying hedge funds, even in portfolios which suffered no client capital redemptions. “This was the biggest hassle for us over the last two or three months because the rapid appreciation of the dollar against sterling and the euro led to currency hedging losses which you have to make good with cash,” he explains. “Which means you have to sell some of the underlying hedge funds to meet the cash call on the foreign currency hedge.” New money Assuming “reasonable” returns, Mr Fawcett expects redemptions to have played out by end of June and net new money to come into the industry in the second half of this year, largely from pension funds. Performance has picked up slightly in 2009 after the reversals of last year, when funds of hedge funds posted a worst-ever decline of 20 per cent for 2008. Hedge funds investing in emerging markets saw cumulative losses of nearly 37 per cent, while the hedge industry as a whole lost 18 per cent last year, according to HFR. So far this year, convertible arbitrage strategies are up 7.68 per cent, short-biased equity long-short funds are up almost 7 per cent and relative value funds are up 2.77 per cent. The good news it appears is that a number of strategies such as distressed debt and equity long-short require little or no leverage to generate returns. “Suddenly you are getting arbitrage opportunities where you can make 20 per cent whereas nine months ago, those same arbitrage opportunities needed leverage to make 5 per cent or 6 per cent,” observes BNY Mellon’s Mr Stewart. “And whereas previously you had to lever an investment two times, now you do not need any leverage to make that return,” he explains. While acknowledging that MGAI specialises in them, he claims that due to market dislocation, right now credit strategies such as convertible arbitrage and distressed debt offer the best risk-adjusted returns relative to equities. “Anything across the credit spectrum is very attractive right now but I would stress on a long/short basis and not long only,” says Mr Stewart. Mr Butler of Kinetic Partners predicts that 75 per cent of hedge fund managers will be up in 2009. But he believes that many funds of funds managers will have to review their business models and rebuild trust. Also, remuneration structures will have to be revisited. “The performance fee should be calculated not on an annual basis but on a longer-term basis,” he maintains. “Even an equity long-short manager needs two or three years to work through their strategy and therefore they should not earn a performance fee for two or three years,” says Mr Butler. Underlying liquidity Fauchier’s Mr Fawcett notes that the biggest change of emphasis for his company is getting more information from the underlying manager on the liquidity of his positions, both in stable and in stressed markets. “The nastiest surprise for everyone last year was how illiquid some assets became, particularly in credit. Some managers had consciously drifted into assets that were less liquid believing they were okay because they had such a large client base,” he explains. Mr Fawcett claims that Fauchier looks harder now at the nature of prime broker relationships maintained by underlying hedge funds have, for instance, to see whether they are multiple or single-prime broker arrangements. The firm, he adds, is also “adamant” that hedge funds should have the assets in their portfolios independently priced. Henry Smith is the editor of FT Mandate

David Butler, Kinetic Partners