October 16, 2006

Hedge Funds: Still Risky Business

In the wake of Amaranth, S&P finds that certain investment practices still could undermine the new controls put on funds

Despite Amaranth's $6-billion one-week loss in September, the largest in hedge fund history, industry sources agree that the effect was little more than a blip. The fund did not default on any of its counterparty obligations, and the impact on global financial systems was essentially negligible. However, the sheer size and speed of Amaranth's losses spotlight the very risky pursuit that hedge fund investing can still be.

In the wake of the headline-grabbing meltdown of Long-Term Capital Management (LTCM) a decade ago, which nearly imploded the world's financial markets, hedge fund managers and the prime brokers that serve them have sought to avoid a repeat of such a crisis. Securities regulators also have been looking at hedge funds to figure out both how to guard against systemic risk and to protect investors who can't seem to get enough of managers in this market.

Over the past decade, progress has been made. Controls have been implemented to decrease some of the larger risks and improve risk-management procedures, and leverage has been reduced. Also, liquidity mismatches, which arise when managers invest in illiquid and inefficient markets but the underlying investor bases have weekly or monthly redemptions windows, have been mitigated. Methods include required holding periods that are now quarterly, annual, and even multiyear; restrictions on withdrawals such as gates (limits on the percentage of fund capital that can be withdrawn); and relatively large redemption charges that penalize withdrawals taken in the first year (or first few years).

HUGE CASH INFLOWS. Return expectations are now much lower compared to the high double-digit expectations (granted, frequently reached) of the late 1990s. Also, the lack of strong and sustained market trends, as well as of range-bound markets, has done a lot to push hedge fund managers to diversify their investment strategies as well as the instruments in which they invest.

The market has responded with huge cash inflows, yielding pools of assets that the most recent published reports put at a cumulative $1.3 trillion and growing fast, as well as substantial activity in exchange-traded funds, which hedge funds use extensively to gain market exposure. Although recent returns have trailed the global equity markets', hedge funds' longer-term risk-adjusted absolute return approach continues to attract assets. With the perception of greater safety and rationality, even pension funds and endowments are allocating a portion of their assets to hedge funds. What was once a market dominated by high-net-worth investors is now dominated by institutional investors.

However, there are no rules to prevent a fund's traders from placing audaciously large bets with assets on hand, no matter what the fund's investment style is supposed to be. According to published reports, that's exactly what happened at Amaranth. Although it was styled as a multistrategy diversified fund, it invested more than 50% of its assets in the energy sector.

One Costly Mistake

In the current low-return environment, the pressure on many hedge funds to gain outsize returns has caused some managers to drift into areas where they're not very experienced. And with so many hedge fund managers chasing all the same pickings, it's tougher to find a sure bet. (More than the number of managers, it's probably the amount of assets, availability of analytical tools that were once proprietary, and overall low volatility across a number of asset classes that have pushed down returns.)

So, although the overall hedge fund category is far more diversified, and counterparties were able to move swiftly to stem any lasting damage from Amaranth, one continued fundamental of hedge fund investing was proven by this scenario: A single set of too-risky investments can undo everything that improved diversification and controls were supposed to prevent. That raises a host of questions, which Standard&Poor's answers here.

What are the primary risks in hedge fund investing today? They fall into two main categories: investment risk and operational risk. Investment risk covers the way in which the fund invests: the strategy (or strategies) used, the amounts allocated to each strategy, the instruments in which the fund trades, and the fund's investment philosophy. It also covers liquidity because hedge fund managers need to match the portfolio's liquidity needs with that of the many illiquid instruments in which they invest. Operational risk incorporates the investment structures as well as the processes and controls used by hedge fund investment managers to implement their strategies. It covers valuation, transaction recording and settlement, corporate governance, and, of course, fraud.

Which risks were expressed with the recent Amaranth collapse? The collapse appears to be an example of risk-taking that ended unfavorably. The fund had highly trained, experienced individuals on its risk-management team as well as systems to monitor the relatively large energy exposures taken. However, Brian Hunter, the 32-year-old head trader for the fund, was permitted to use a high-risk strategy similar to one that has been successful in the past. Unfortunately for Amaranth, this time it was not.

Will Amaranth's meltdown squelch investing in hedge funds? At this point, that scenario is unlikely. Investment assets were flowing into hedge funds at a remarkable clip before Amaranth's big loss and are still doing so. The strategies many hedge funds employ to achieve lower volatility and higher risk-adjusted returns over time continue to attract assets, even though few hedge funds today still reap the very high returns of the 1990s. Indeed, a hedge fund with such returns, especially if coming from only one sector, should be a red flag to investors. Due diligence by hedge fund investors cannot end with the placement of funds but must continue throughout the life of the investment.

Will changes emerge from prime brokers and hedge fund managers to mitigate the potential for such losses in the future? For hedge fund managers, the dreaded"D"word--disclosure--is going to raise its head, most likely at the insistence of hedge fund investors. Traditionally, presentations by hedge fund managers provide details about the fund's investment philosophy and style, but offering documents are far sketchier and give traders unusually broad latitude for implementation. From what we have been hearing, investors will most likely demand far more detail about investment strategies and guidelines in the offering documents and will want tighter terms and conditions around implementation.

Whether prime brokers will require more collateral from hedge fund managers is still unknown. Interestingly, one reason the LTCM failure was so spectacular was that its prime broker required far lower levels of collateral than, in hindsight, would have been prudent. So the enormous leveraging in which the fund's traders engaged was backed, comparatively, by not much more than the traders' reputations.

We expect to see hedge fund managers and prime brokers be much more cautious about their counterparty relationships. In a potential meltdown situation, unresponsive counterparties can exacerbate liquidity difficulties to the point where losses wind up being greater than they needed to be.

Are formal regulations likely to be strengthened? Securities regulators have long focused their attention on hedge funds. Questions surrounding whether to increase oversight will continue to be under the microscope for some time.

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