From the October 2007 issue of Investment Advisor • Subscribe!

Sub-Prime Returns Redux

August appears to have been the worst month for hedge funds since May 2006, when 70% of all hedge funds fell. The first two weeks of the month saw continued woes in subprime mortgage securities, and many long/short market neutral quant funds began to unexpectedly see their long positions fall, and their shorts rise precipitously.

These leveraged hedge funds had to unwind their positions in order to de-leverage, by buying back the short positions and selling the long positions, to varying degrees, which just drove prices the opposite way of how they need to perform and increased volatility.

Most hedge fund managers took their lumps in the unwinding process, but others like Goldman Sachs decided to de-leverage by increasing the denominator of their fund through offering fee incentives for new shareholder investments, effectively reducing leverage by increasing the net asset base.

Industry sources cited the $6 billion Tudor BVI Global Fund falling 5.5% in August, the $6 billion Raptor Fund falling 5.6%, Caxton's $11 billion flagship fund off 4.8%, Moore's $7 billion Global Fund off 5.7%, and New York-based Third Point off 8%, just to name a few.

Those who had to sell were hurt badly, while those were able to weather the storm saw these strategies rebound off of their lows to finish flat or up slightly for the month. The unknown is the extent of redemption requests hedge funds have received for September 30th. A slew of funds may now be forced to liquidate significant positions sometime this month to meet that demand.

Some Mutual Fund Hit Hard, Too

Many of the open-end mutual funds that use hedging strategies, especially those with the term "market neutral" in their names, had problems as well. Some were down over 10% in a span of four days. Hardly any of these funds employ leverage, but many had to unwind nevertheless, due to a wave of mid-month redemptions from skittish investors who had not thought such a precipitous drop was possible in a hedged portfolio, or due to quant models triggering sell signals.

In the aftermath, strategy diversification of fund-of-funds and some multi-strategy approaches did well to mitigate exposure. But in the hedged mutual fund space, there are very few funds that are more than just one manager and/or one strategy. Lee Schultheis, manager of the longest tenured of the multistrategy funds, AIP's $600 million Alpha Hedged Strategies Fund (ALPHX), noted that "our in-flows grew to a record of $78 million in August, primarily due to the problems experienced by our single-strategy peers." The fund was down only 0.07% in August and was still up 6.00% YTD.

Helping to avoid a big mid-month drawdown was the fund's broad array of strategies, with 22 active managers running a diverse mix of styles including long/short equity, fixed-income arbitrage, distressed securities, and others. Even the subprime woes were put to good use as Schultheis noted "we were positioned slightly net short with respect to subprime in our fixed-income arbitrage strategy, and that subaccount actually was up almost 10% in August. But the key to being highly diversified and consistent, especially when the markets are tumultuous, is to not take large net exposures, and keep a broad mix of strategies active at all times."

Schultheis's fund is the No. 1 Lipper Equity Market Neutral Fund for the last three years as of August 31, 2007, and will reach the five-year mark this month.

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