Hedge funds face Darwinian Rule
Hedge funds are the Galapagos islands of the financial services industry, with participants following Darwinian rules. After periods of relative stability they will undergo periods of intense change as participants evolve to take account of new realities.
For much of this decade, hedge funds had appeared to evolve far more nimbly than their brothers in the regulated financial industry. At the beginning of this decade, as the conventional “long-only” equity funds that dominate the retirement saving industry were suffering severe losses in the wake of the bursting of the internet bubble, hedge funds avoided losses. That spurred huge new investments in hedge funds by wealthy individuals. In this decade, they dominate trading volumes and, in the short term, move markets.
What let them survive and flourish? Apart from being small, nimble and, in some cases, smart, they had three key advantages.
Unlike most conventional funds, they can sell stocks or commodities short, to profit from declines in price. They can borrow; a trade that makes not even 1 per cent is worth doing if you borrow enough money to make the same trade 10 times(10x leverage). And they can limit withdrawals by investors, allowing them more flexibility than funds that must be prepared for redemptions every day.
For the first year of the credit crisis that began last July, they remained at least one evolutionary step ahead of the herd. Judged as a sector, hedge funds continued to make money as equity funds lost badly.
But something happened to disrupt the delicate ecology of the Galapagos. Hedge fund indices differ widely but they agree that hedge funds started to lose money in July – and lost it in a big way in September.
Why? This must be guesswork, but a popular hedge fund strategy involved selling short the stocks of banks while betting on energy prices to increase. The argument was that lower rates to combat the credit crisis would feed through into inflation and cause funds to flow into oil. In the year to mid-July, this trade netted 345 per cent. But then the oil bubble burst. Since then, the “long oil short banks” trade has lost 57 per cent.
The end of September gave hedge fund investors one of their periodic opportunities to remove money. It appears many took it. According to Hedge Fund Research, $31bn was yanked from the sector in the third quarter. TrimTabs estimates that withdrawals were even higher, at $43bn in September alone.
Meanwhile, the Lehman Brothers bankruptcy in mid-September prompted a sudden increase in the price of leverage as investment banks on whom hedge funds rely for their short-term funding applied much tighter restrictions.
Then came the ban on shorting financial stocks. All hedge funds’ critical evolutionary advantages had been removed. Once hedge funds cracked, equity markets also cracked, with the MSCI World index falling more than 30 per cent since early September. The “crash” of last week was followed by the most volatile week in history, with huge and utterly illogical swings as funds struggled to reconcile their positions. On Thursday afternoon alone, while oil prices fell, the S&P energy index rose 14 per cent, raising its market value by about $140bn. Hedge funds were the marginal investor.
So this credit crisis help the participants in Galapagos islands crowded out losers. Leverage, as the chart shows, was vital to the eco-system of the Galapagos. Hedge funds’ great outperformance dates from a period when leverage was historically cheap. While markets stayed stable, that leverage made hedge funds look much nimbler than the rest.
For much of this decade, hedge funds had appeared to evolve far more nimbly than their brothers in the regulated financial industry. At the beginning of this decade, as the conventional “long-only” equity funds that dominate the retirement saving industry were suffering severe losses in the wake of the bursting of the internet bubble, hedge funds avoided losses. That spurred huge new investments in hedge funds by wealthy individuals. In this decade, they dominate trading volumes and, in the short term, move markets.
What let them survive and flourish? Apart from being small, nimble and, in some cases, smart, they had three key advantages.
Unlike most conventional funds, they can sell stocks or commodities short, to profit from declines in price. They can borrow; a trade that makes not even 1 per cent is worth doing if you borrow enough money to make the same trade 10 times(10x leverage). And they can limit withdrawals by investors, allowing them more flexibility than funds that must be prepared for redemptions every day.
For the first year of the credit crisis that began last July, they remained at least one evolutionary step ahead of the herd. Judged as a sector, hedge funds continued to make money as equity funds lost badly.
But something happened to disrupt the delicate ecology of the Galapagos. Hedge fund indices differ widely but they agree that hedge funds started to lose money in July – and lost it in a big way in September.
Why? This must be guesswork, but a popular hedge fund strategy involved selling short the stocks of banks while betting on energy prices to increase. The argument was that lower rates to combat the credit crisis would feed through into inflation and cause funds to flow into oil. In the year to mid-July, this trade netted 345 per cent. But then the oil bubble burst. Since then, the “long oil short banks” trade has lost 57 per cent.
The end of September gave hedge fund investors one of their periodic opportunities to remove money. It appears many took it. According to Hedge Fund Research, $31bn was yanked from the sector in the third quarter. TrimTabs estimates that withdrawals were even higher, at $43bn in September alone.
Meanwhile, the Lehman Brothers bankruptcy in mid-September prompted a sudden increase in the price of leverage as investment banks on whom hedge funds rely for their short-term funding applied much tighter restrictions.
Then came the ban on shorting financial stocks. All hedge funds’ critical evolutionary advantages had been removed. Once hedge funds cracked, equity markets also cracked, with the MSCI World index falling more than 30 per cent since early September. The “crash” of last week was followed by the most volatile week in history, with huge and utterly illogical swings as funds struggled to reconcile their positions. On Thursday afternoon alone, while oil prices fell, the S&P energy index rose 14 per cent, raising its market value by about $140bn. Hedge funds were the marginal investor.
So this credit crisis help the participants in Galapagos islands crowded out losers. Leverage, as the chart shows, was vital to the eco-system of the Galapagos. Hedge funds’ great outperformance dates from a period when leverage was historically cheap. While markets stayed stable, that leverage made hedge funds look much nimbler than the rest.
Labels: crisis, hedge fund
posted by Jiu Zhuang at
4:31 PM
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