Alpha - September 2007 - (Page 38)

Market Turmoil loans in different tranches began to correlate. Longtime risk manager and hedge fund executive Richard Bookstaber describes the phenomenon as a form of infection: In this instance, he says, sickly subprime mortgages, packaged with other debt instruments, contaminated those neighboring bonds regardless of their ratings. Bookstaber, author of the recently published book, A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation, draws an analogy to what happens when a stock is added to the S&P 500 index. It suddenly has a higher correlation with the other stocks in the index, not because it has anything more to do with them economically, but simply because it is now part of the S&P package. The same is true, he explains, when a bond is part of a CDO. “It doesn’t matter if one of the underlying bonds is issued by a AA-rated energy company — D. ELLEN SCHUMAN and another by a BB-rated fiCIO, CARNEGIE CORP. OF NEW YORK nancial,” Bookstaber says. “The bonds in the package might end up moving in lockstep. And — not unexpectedly — this will most likely happen during a credit-based event, like the subprime meltdown.” In such circumstances the correlation pressure is often ratcheted up by the actions of prime brokerages, which become concerned about potential fund failures. In the most recent period of turmoil, banks responded to the spread of losses related to the subprime mortgage market by upping their margin calls — asking for more collateral from their client hedge funds — to guard against the risk of default. For hedge funds already squeezed by losses, those margin calls meant that they had to sell whatever liquid assets they could to come up with the cash. As a consequence, volatility spread to the equity markets, and other seemingly unrelated hedge fund strategies began to suffer. “The question investors have to ask is, If everything correlates during a period of market dislocation and ends up having the same problem at the same time, how do you protect your portfolio?” says Andrew Fishman, president of Schonfeld Group Holdings, which manages a $250 million fund of hedge funds for high-net-worth investors. “It’s not easy. It doesn’t matter whether you’re a great individual manager or a great fund-of-funds manager. It’s tough when all of the asset classes and all of the strategies suffer simultaneously.” ious to — the potential risks, believing that the bigger the hedge fund ﬁrm, the better its risk management. But there is nothing about size that provides a safety net, as investors in Amaranth Advisors discovered to their chagrin a year ago. Throughout most of its history, Greenwich, Connecticut–based Amaranth was a multistrategy manager with a core focus in convertible arbitrage. By mid-2006 the firm had $9 billion in assets under management, but about half of that was in energy trading, an area in which it had less expertise — and less-effective risk management. Amaranth’s senior energy trader, Brian Hunter, inadvertently bet the entire firm when he went long natural gas that year using a lot of leverage; as his positions moved against him and the spreads on his futures contracts narrowed unexpectedly, the firm lost billions: $2.5 billion in trading alone, in the ﬁrst two weeks of September 2006. Amaranth ultimately gave up even more in concession payments and trading losses, bringing the total to a stinging $5.5 bilion. Despite such cautionary tales, investors still seem to believe that putting money into a $10 billion hedge fund is somehow safer than entrusting it to a $200 million manager. Experienced hedge fund industry insiders beg to differ. “Size and safety are not equivalent,” Fishman says. “Size gives you an opportunity to build an infrastructure that promotes risk management and safety, but it’s not the same thing. At the end of the day, you really have to understand the strategy your hedge fund managers are using, what problems they might potentially come up against and how they will react.” Be leery of leverage. Whenever excess leverage, ﬁnancial innovation and hedge fund hubris collide, losses are likely to follow. This should be obvious by now, but it seems to be forgotten by successive generations of hedge fund managers — and their investors. In early 1998, Long-Term Capital Management was using leverage of more than 25 times assets under management, which founder John Meriwether and his team of Nobel Prize winners believed to be perfectly reasonable. However, when LTCM’s carefully designed quant model went haywire in the face of the Russian debt crisis later that year, the fund shed $4.6 billion and had to be salvaged with a $3.65 billion bailout from 14 Wall Street firms orchestrated by the Federal Reserve Bank of New York. Eight years later Amaranth’s Hunter was using leverage of six times assets to make his multibillion-dollar bet on natural gas. This summer Sowood’s Larson was reportedly using leverage of ten times assets. His investors, though, were clearly informed about the leverage he was using and his hedging techniques; no one can claim that they didn’t know the risks. Forced liquidations like that experienced by Sowood are one of the reasons hedge funds are being accused of exacerbating market movements: When they have to unwind, the repercussions travel far beyond their own ﬁrms, adding to overall market volatility. Matthew Rothman, “Every ﬁve years or so, managers that use a lot of external leverage take a big hit.” Size is no guarantee of safety. When hedge fund managers gain a reputation for making money, assets are sure to follow. Unfortunately, for investors, managers who succeed in raising billions tend to move away from their core expertise and add more strategies. Investors seeking access to top managers often ignore — or are obliv38 • INSTITUTIONAL INVESTOR’S ALPHA • SEPTEMBER 2007

Table of Contents Feed for the Digital Edition of Alpha - September 2007

Contents Letter from the Editor Longs & Shorts Pension Corner: Keeping the Faith The Good Guys: Going Public Interview: Barry Bausano - A Delicate Balance Cover Story: Cruel, Cruel Summer Profile: Phil Cooper - Alternative Flight Plan Strategies: Marshall Wace - TOPS in Its Field Profile: Fortis Investments - Banking on Alternatives Research Center: Top Equity Trading Firms Alpha Bytes: Desktop Duel Unhedged: Commentary - The Taxman Cometh

Alpha - September 2007

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