Institutional Investor's Alpha Magazine - March 2008 - (Page 43) Liquidity Crisis that it is absolutely impossible for anyone, any firm, any anything, to get their arms around it.” Although a fortunate few may profit from the uncertainty, there are always more losers than winners, Zehner notes. Hedge funds’ ability to mask trading positions and to hide assets and capital that could serve as a buffer against market shocks can ultimately contribute to the instability. “When a hedge fund blows up, it renews fears among investors that things are happening that they don’t fully comprehend,” says Bruner. “Information asymmetry, in short, amplifies anxiety.” An asymmetry of information was also partly to blame for the ripple effect between the subprime mortgage and the hedge fund markets, says the IMF’s Dodd. The inability of markets to immediately identify the nature and location of the huge subprime risk — again because of the inscrutable nature of big hedge funds — led inevitably to a sudden shift in risk assessment. “Once overly optimistic about the risks of the subprime market, scared and confused investors suddenly panicked and overestimated risk, shunning even senior, investment-grade tranches,” Dodd explains. This process, brutal and swift, caught even the best managers — Jeff Larson and Peloton Partners included — completely off-guard. The future promises similar turmoil unless transparency in hedge fund pricing becomes the norm, says Craig Asche, executive director of the Chartered Alternative Investment Analyst Association, an Amherst, Massachusetts–based trade group. For instance, all the trouble with CDOs was exacerbated because there were no market prices to serve as benchmarks and no way to determine the value of the various risk tranches. “The question is, ‘What is appropriate?’” Asche says. “How does someone mark to market something that at one point may have been trading on a fairly regular basis but is no longer?” In situations where there are multiple bids and a large dispersion between the bids, Asche says managers need to be able to see the prices at which similar securities have traded. They also need to compare the bids against their models, using a variety of methods to make sure the prices make sense. Asche believes that market forces will require hedge funds to offer such detail sooner or later. “If investors understand the process, they will be comfortable,” he explains. “The difficult part for fund managers will be trying to anticipate all the possible variations they may have to face down the road, rather than doing it on an ad hoc basis.” TRANSPARENCY, HOWEVER, ISN’T ENOUGH. It’s imperative that hedge funds curb their leverage habit as well, some critics say. Like many hedge funds, Sowood relied heavily on borrowed money, at one point exceeding ten times available capital. (Typical hedge fund leverage in the purchase of high-yield tranches is about five times available capital.) Whatever liquidity Larson believed he had proved irrelevant. The hedge funds that failed to survive the liquidity crisis had one thing in common. “Specifically, these hedge funds had relatively short financing or redemption terms compared to peers, particularly in strategies that involved illiquid or significantly levered assets,” says Callan Associates’ McKee. Though Sowood’s holdings fell irrespective of quality — thus undermining the fund’s “beta neutral” strategy, which was meant to mirror the broader market — the losses were worse because of Larson’s heavy use of leverage, particularly when he was forced to sell securities bought on margin. By comparison, hedge funds with longer-term financing were in a stronger position to stay the course, notes McKee. “The ultimate measure for each and every fund,” he says, “is the long-term resolve of its investors and lenders.” A case in point involves the respective outcomes of the highly leveraged Sowood versus the sufficiently risk-capitalized Citadel, which profited handsomely from Sowood’s demise. — ROBERT BRUNER, DEAN, (Citadel picked up about $4 bilDARDEN GRADUATE SCHOOL OF lion in Sowood securities at a 20 BUSINESS ADMINISTRATION percent discount to face value; in 2007, Citadel, led by CEO Kenneth Griffin, chalked up gains in excess of 30 percent, compared with an industry average of 12 percent.) At a recent conference titled “The Myths and Reality of Managing Liquidity Risk,” Bjorn Pettersen, a risk management expert with Chicago-based consulting firm CRA International, said during a presentation that it was obvious that better-financed funds like Citadel are on firmer ground than are certain others. “Any hedge fund that is highly leveraged and is really depending on the prime brokers for funding, unless it has some massive liquidity pool, is going to be in a world of trouble,” he said. The problem with constantly borrowing to multiply returns is that managers require a continuous intake of investment capital, explains Donald Brownstein, CEO and founder of Stamford, Connecticut–based hedge fund firm Structured Portfolio Management. “And if the tide starts going out, the risk premia will go up, spreads will widen, and the dimension of leverage you’ve chosen will determine how exposed you are to that widening.” The bigger danger, Brownstein says, is that returns generated exclusively with leverage tend to promote even greater use of leverage. “That’s because your spreads are going to tighten and you’re making more money, so therefore you have to invest more money, which tightens the spreads even further,” he says. “All this money is actually “When a hedge fund blows up, it renews fears among investors that things are happening that they don’t fully comprehend.” MARCH 2008 • INSTITUTIONAL INVESTOR’S ALPHA • 43
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