By Eric Uhlfelder
Published: August 31 2008
Can hedge fund investors sidestep meltdowns?
Take the collapse of Bear Stearns’ high-grade structured credit and structured credit enhanced leverage funds, which reportedly invested primarily in triple A-rated tranches of mortgage-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 market, it turned out that the managers were not sufficiently hedged after all and that both funds were more highly leveraged than investors understood.
Managers had initially borrowed against their original capital base before then leveraging up. This meant that 5 and 10 times leverage was really 10 and 20 times. Unbeknownst to investors, a special financing covenant with Barclays made the British bank the sole equity investor in the enhanced fund, leaving all other investors with no actual ownership rights.
To cut a long story short, when the market for mortgage backed securities froze and there was no meaningful security pricing, these funds plummeted in value. Leveraging banks withdraw their financing, and the funds were dissolved.
This was no surprise to some. According to Jonathan Kanterman, managing director at the fund of funds group Stillwater Capital Partners with $925m (£504m, €626m) under management, “ given the funds’ true 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 software solutions that helps asset managers and hedge funds control risk, says that given the potential illiquidity 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 turbulence.
Riskdata helps 150 clients with assets of more than $500bn avoid such meltdowns by forecasting the impact of hundreds of scenarios on funds for both institutional hedge fund investors and managers of funds of hedge funds.
“We aren’t market forecasters,” says Mr le Marois, “rather, we provide investors 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 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 software 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 historical data over a hedge fund’s long-term performance, Riskdata projects the likelihood of various outcomes for the fund. Its software tries to identify vulnerabilities and possible solutions.
But to help discern potential risk, Riskdata will measure key variables going back before the fund’s own history began. For example, Mr le Marois cites a US fixed income fund that started up in June 2005. Over the following three years, it generated average monthly performance of 80 basis points, monthly volatility of 0.4 per cent, and the worst monthly drawdown of -0.66 per cent.
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 largest 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 performance increased 12 basis points over its norm.
Given that spreads declined an average of 7 basis points during the life of the fund, historical performance would suggest limited 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 investment 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 may not have otherwise known existed”. But she adds that these findings need to be further assessed in a qualitative review.
Jiro Okochi, chief executive of Reval, a risk management solutions provider, recommends investors review a fund manager’s track record running different funds. He warns that projections based on historical review could be misleading if a manager’s current strategy and portfolio has deviated from the 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 Kanterman of Stillwater Capital Partners also assesses how professionally a firm is run. Transparency is critical. Does performance consistently correlate with strategy, or does it suggest that the fund has exposure in unexpected 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 transactions become the benchmark on which valuations are based. “When you have extreme swings in asset pricing 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 loan facilities pulled on short notice.”
Ultimately, most industry observers agree that quantitative analysis can enhance transparency. But its findings should be qualitatively filtered to know their true meaning and to help avoid false reads.
Copyright The Financial Times Limited 2008
http://www.ft.com/cms/s/0/29d5939c-75f4-11dd-99ce-0000779fd18c.html?nclick_check=1
Lisa Krow 