No place to hide

The compression of the market brought on by the global credit crisis has left hedge funds feeling the squeeze. But with no quick fixes to hand, a period of consolidation at the end of what has been a boom period has to be the best option, argues


No place to hide One thing that has become clear over the course of the past year is that capital movement is truly global.

There is little doubt that the adverse economic situation unfolding principally in the developed West has impacted severely on the level of investment into hedge funds and also asset classes sought out by investors as they wait out this period of uncertainty. ­Markets are interrelated as never before. As the vast majority of hedge funds are offshore funds, we tend to see the trends and issues affecting hedge funds unfold. This is what we see in Asia and more globally.

Counterparty risk

Hedge funds have long confronted counterparty risk with a mixture of dread and ­indifference. Historically, very little verification of a large prime broker’s balance sheet or financial situation has been done prior to going into business with them. The past few months of collapses and near collapses of brokers throughout the financial world have changed attitudes and industry practices significantly. Hedge fund managers have a duty to be diligent and have a duty of care over the assets of their investors’ funds.

The only viable option in the shifting dynamics of the credit crunch appears to be that advocated since the inception of hedge funds – encouraging multiple broker ­relationships. In theory this should give hedge funds the opportunity to react to counterparty risk and to spread assets, but in practice it is less clear that it provides much of a solution.

Notably, it is unlikely that a manager would be aware of an imminent failure. It can also be argued that splitting up broker relationships means that the full picture regarding exposure, collateral and positions held by various brokers with a single hedge fund counterparty becomes opaque, and that this increases market risk. Multiple broker relationships are also often only entered into once the hedge fund has ­sufficient scale to justify the relationships.

Nevertheless, it is a topic much spoken about and every manager must be aware that investors will require detailed information about the prime brokers and the steps taken to minimise counterparty risk.

The return of absolute return

After several long years of boom time and accelerating upward slanting charts, the term ‘hedge fund’ began to take on a different meaning entirely. No longer were managers expected to hedge all of their positions; indeed a long bias was almost essential just to keep pace with skyrocketing equity markets.

Looking back, it is evident that hedge fund managers must all consider ruefully how the events of November 2007 through January 2008 exposed that unfortunate shift in the industry that has to an extent damaged the brand. China’s indices have fallen off some 45 per cent, the Hang Seng Index (HSI) is down 25 per cent, and markets around Asia have generally suffered double-digit declines.

Hedge fund losses were severe and a shakeout has ensued, bringing the true meaning of the term ‘hedge fund’ bumping back down to earth.

Benchmarking is ­popular for some market segments, particularly pension funds and the like, but for adherents of absolute returns it is a word they tend to look down on. Absolute return strategies by their very nature do not adhere to any benchmarking, and while investors may suffer some volatility in the short term, the strategy tends to attract those that like to see positive returns irrespective of market conditions.

The current economic climate has rekindled among investors a desire to invest in absolute return strategies – which aim to post a positive monthly performance, a return above the London Interbank Offered Rate, or perhaps volatility that is lower than equities, for example – rather than beat a benchmark such as the HSI, for example, over the defined period.

Compression of the market

Hedge Fund Research reports that since the onset of the credit turmoil in the $2.65tr (£1.32tr) industry, the number of hedge funds winding down operations has jumped. Figures suggest that closures are up about 20 per cent in the first quarter of 2008 alone, while start-ups are at their ­lowest levels since 2000.

The numbers point to a reality in the ­market – namely, that there is compression in the market as nervous investors turn away from risk and seek perceived shelter with larger, more established operations. A cynical view might be, as the saying goes, that “no one ever got fired for buying IBM”. But in fairness, in times like these, investors will express a preference for funds with strong and established tracks records and significant infrastructure.

As well as facing the economic whirlwind, investor confidence in hedge funds is at an all-time low and many hedge funds face closure. With new money flowing into hedge funds declining, it is the smaller funds that are suffering the most, even the high-fliers. Sign of compression in the hedge funds space is clearly evidenced by the decline in the overall numbers of funds launched ­globally in 2007, which is down by nearly 50 per cent on the 2005 peak.

The expectation is that the consolidation may be at or close to an end, but it is sobering to note that the largest 100 hedge funds accounted for three-quarters of total ­industry assets in 2007 – up from 54 per cent in 2003. The largest 3 per cent of hedge funds accounted for four-fifths of total industry assets in 2007. These numbers speak volumes about what has been taking place in the hedge fund market.

While opinions vary, it appears clear that hedge funds in Asia are pretty much as afflicted as those in New York or London. New money is hard to come by and cash – or private equity – is a popular choice. Growth in emerging markets such as Asia has been rather more muted than one might expect, and in gross terms assets under management have increased only marginally from 5-7 per cent over a five-year period. Although activity seems at times frenetic in Asia, Hong Kong – long regarded as the most viable and largest of the asset ­management bases in the region – has not managed to keep pace with or catch up with the traditional centres such as London and New York, which together claim about 60 per cent of global assets under management.

Considering the health of the industry and the speed at which it has ballooned, one might feel that a little consolidation and introspection might be a good thing.

Duncan Smith is the managing partner at Ogier in Hong Kong