The traditional long-only investment industry derives its reputation for relative stability not from some unique attribute of its managers, but from the attributes of their underlying investments – the perceived stability of their securities and the safety in numbers that comes from being part of the “beta heard”. As a result, traditional investments are often portrayed as the low-risk straight-man that is forced to put up with the antics of those whacky hedge funds. But while they are certainly sources of idiosyncratic risk, hedge funds may hold one trump card over their long-only cousins – genetic diversity. Idiosyncratic risk can be diversified away, but long-only investments are more likely to experience pain from common underlying investments or strategies. Today, for example, there was a run on Putnam’s institutional money market fund – even though it had no exposure to Lehman, WaMu or AIG. In other words: just ‘cuz.
The recent calamities have revealed a subtle shift in thinking about hedge funds. What follows are several stories we’ve been following today that illustrate this:
- The global hedge fund community, long accused of being a poster child for excess leverage may not have been the drunken sailors describe by many financial commentators. Yesterday, Thomson reported that:
- “funds are keeping borrowings and risk low and seeking sanctuary in safe-haven assets during the current market turbulence…”
- Online Financial News also reports that (contrary to popular assumptions), hedge funds are de-levering big-time:
- “Hedge funds have increased their cash assets to nearly one-third, one of their highest levels ever, as poor returns and the turbulent markets increase the possibility of mass redemptions from the sector at the end of the year.”
- The Financial Times blames the dwindling ranks of prime brokerages for hedgies’ newfound love of cash:
- “Funds are being forced to de-lever and sit on large cash balances as the prime brokers they largely depend on for financing face severe pressure.”
- The result, concludes the FT is that the future growth of the hedge fund industry is now “in doubt”. But is that really true? HFR reported this week that first half 2008 net closures of hedge funds were up over the same period a year earlier. According to Hedge Funds Review, this means that 7% of hedge funds will close this year – vs. 5.95% last year – a whopping 1.05% increase. Not quite an industry blow-up compared to something really risky, like, for example, money market funds.
- While we’re on the topic of money market funds, why is it that when hedge funds suspend redemptions, it’s described as a “blow-up” and blamed on investments that the manager isn’t even able to value properly. But when a money market fund suspends redemptions, it’s described in decidedly more sanguine terms:
- “To prevent losses on the Putnam fund’s investments, which would’ve occurred had the securities been sold quickly to redeem the shares, the company plans an orderly sale and will distribute the proceeds to the shareholders.”
- The Times, for one, has come around today to the fact that hedge funds are not the source of all evil after all. The paper makes an argument that we also made in the summer of 2007 – that hedge fund stocks could technically experience a bubble, but that hedge funds themselves were just meta-securities with no inherent value on their own.
- “There’s a pattern here. The biggest shocks to the financial system have all come from stock market-quoted companies. By contrast, hedge funds, which many expected to cause trouble, have been innocent bystanders.”
- Pension trustees can also see the writing on the wall in the long-only investment industry. Professional Pensions quotes one consultant who says that:
- “…our clients are increasingly looking at hedge funds as a way to preserve capital and control their exposure to market volatility while still seeking return. Once again this underlines how such strategies are being viewed in the risk management context, rather than purely as a driver of return, as hedge fund strategies typically have a low correlation to traditional asset classes.”
- The result? Continued growth for the hedge fund industry, according to data cited by FINalternatives.
- “Funds of hedge funds showed the first signs of an asset slowdown in the first half of 2008, but still posted a net inflow of some $50 billion despite volatile markets and lackluster returns.”
- …and by HFN:
- “Despite the market’s volatility in August and more recently in September, there are a large number of funds in several different strategies which are performing very well amidst one of the most difficult environments in recent history.”
The bottom line: a new type of “redemption” for hedge funds. As Dow Jones reported yesterday:
“It’s inevitable that hedge funds, with their lack of transparency, reputation for catering to the rich, and with the Hollywood lifestyles of some of their managers, are going to continue to get blamed when things go wrong in financial markets. After all, it’s fun, it’s easy and just like there’s no way to prove whether the blame is warranted, there’s no way to prove that the blamer is wrong for doing the blaming.”
No way to prove the “blamer is wrong”. But just in case hedge funds aren’t actually to blame for the end of the world as we know it, you can always argue that their “secrecy” has simply covered up the blow-ups and flame-outs. As Canada’s Financial Post wrote today:
“Operating largely outside public markets and regulatory scrutiny, the failures, too, may take place largely behind the scenes and may already have begun.”
Apparently, truth is the first (okay, maybe fifth or sixth) casualty in this war.