FYI | May 03 2007
By Greg Peel
Back in 1998, hedge funds were still a relatively new and little understood class of managed fund. So when the world’s biggest hedge fund at the time – Long Term Capital Management – went under with billions in losses from playing Russian debt, the monetary officials of the world had kittens.
Hedge funds sprang up mostly post the 1987 crash when suddenly everyone, particularly large managed funds, became very conservative in their investment strategies and risk profiles. This frustrated the new breed of smart investment managers so many left to form their own small funds and solicit high net worth individual investment. The move coincided with a rapid increase in the number and diversity of derivative instruments created across all financial markets. These smart, computer-model savvy investors were the world’s experts in identifying and exploiting price mismatches between fundamental and derivative markets.
Hence the name “hedge fund”. As most activity was concentrated in buying an underlying instrument and selling its derivative, for example, or buying one stock and simultaneously short-selling another, the fund’s position was deemed to be “hedged”.
Today, the name seems almost contradictory. The label of “hedge fund” has been given to any small managed fund that enters into either traditional or non-traditional markets looking for premium returns for their investors. Often, today, those premium returns are associated with higher risk. “Hedge” no longer seems very appropriate.
Such it was that in 1998 LTCM lost the big bet it had taken on the emerging world of Russian debt, which had been valued down to low levels post the collapse of communism. LTCM was expecting Russia to emerge a democratic financial powerhouse, but instead the system collapsed. Russia defaulted on its debt and LTCM went down with some US$3.6 billion in losses. Most of the world’s big banks were lenders.
The global official sector, including the US Fed, had already begun a campaign against derivative instruments post the ’87 crash, in which computer-activated selling to cover short option positions was apportioned blame. When LTCM went down, focus moved not just to the derivatives but to the greatest exploiters of derivatives – the hedge funds.
Nevertheless, the global hedge fund market has since grown to an estimated value of US$1.4 trillion. This is enough for the Fed to become rather concerned. It is not just the size of the market that is ominous to the Fed, it is the concentration of risk.
Reuters reports Fed economist Tobias Adrian as saying “Recent high correlations among hedge fund returns suggest concentrations of risk comparable to those preceding the hedge fund crisis of 1998”.
Railing against hedge funds is not a new sport. Those taking the other side of the argument suggest that in 1998, LTCM was one massive hedge fund in a pool of not many. Today there are hundreds of hedge funds, mostly comparatively small, invested in a wide range of markets and countries. Because of this diversity and spread, any single failure will not be enough to cause a crisis.
In fact, last year a fund by the name of Aramanth Advisors made losses of some US$4.5 billion playing the natural gas market. While there many banks and large pension funds hurt by the losses, the amount represented only half of the fund’s earlier paper value. Once again there were strong warnings about hedge funds, but the market shrugged and moved on.
Returning to the Fed’s fears about concentration of risks, the rapid unwinding of yen carry-trades which occurred following the Shanghai Surprise earlier this year is a likely indicator of where some of this concentration might lie. But again, the fear in February and March was short-lived, and the world is back on track.
Nevertheless, the Fed is worried that too many hedge funds, representing too much money, are showing very similar movements in returns. This suggests it might only take one shock in markets (perhaps commodities or equities for example) to spark a concentration of panic unwinding and flight from risk. The Fed is not, however, pushing for regulatory intervention. It is simply warning hedge funds’ financiers – the big banks – to be very careful.
While hedge fund investment grows to dizzy new heights, another market that can provide concern – that of the private LBO – has been linked to a 79% increase in European junk bond issues for the first quarter of 2007 over the same period last year. The Financial Times quotes the European High Yield Association as suggesting markets have ridden out the storm of February-March and the US sub-prime scare and the world economy is in “robust health”.
Gilbey Strub, executive director of the EHYA, said: “The European macro-economic environment continues to be favourable due to very low interest rates while issuance levels are being driven by mergers and acquisitions and leveraged buyout transactions.”
Globally, M&A activity topped US$1 trillion in the first quarter which is the highest figure ever. A record of US$224 billion in high-yield debt was brought to the market in the quarter, 80% of which was leveraged loans.
Are we worried?