Hurricane-proofing your hedge funds

The hurricane screaming through markets in September blew away plenty of hedge funds. Many of those still standing saw significant assets sucked into the vortex. They face short-selling restrictions, and can expect tighter regulation; if their prime brokers aren’t freezing assets, calling for margin or going bust, they are certainly demanding bigger haircuts. “From their investors most are encountering a hostility that can hardly be unexpected,” says Aoifinn Devitt of Clontarf Capital, which advises family offices and institutions on alternative investments. “For some groups, typically those most exposed to high net worth and retail money, the outflows will be nothing short of catastrophic - up to 50 per cent of assets in some cases.” According to HFR and Eurekahedge, September saw about $30-35bn (E23.4bn - E27.3bn) yanked from the industry. Assuming they want to stay in the game, what questions should wealth advisers ask their fund of funds manager? The first might be, “Who’s investing alongside me?” Many redemptions have been from investors forced to sell to cover losses in other, less liquid parts of their portfolios, so it pays to allocate alongside long-term investors with decent cash buffers. “It can be difficult to be sure who your co-investors are within hedge funds ,” notes Paul Sarosy, managing director and head of product and sales management at Credit Suisse's private bank. “But it’s a valid question, and I think we will see an increased focus on transparency in the future.” Chris Manser, global head of hedge funds with AXA Investment Management, which has just started marketing its funds of funds after two years running $4bn of Axa insurance money, talks up the stickiness of that capital. “It makes the difference between being able to run the portfolio you want or the portfolio you are forced into,” he says. And what is “the portfolio you want”? If you expect more volatility logic suggests rebalancing away from market-neutral and arbitrage towards directionality. “Volatility creates opportunity,” says Julian Shaw, head of risk management at $38bn fund of funds firm Permal, whose clientbase is three-quarters private wealth, and as such has always had a directional bias. “The storm creates the opportunities and the calm is when you realize the profit from those opportunities. You need to find managers who can weather the storm without panicking or being stopped-out.” Lately the markets have made Permal’s slightly higher volatility – but low tail risk – a much easier sell. “I can’t help feeling a bit of schadenfreude towards some of the funds investing in things like fixed income arbitrage,” Mr Shaw admits. “People kept saying they knew a fund that offered returns like ours but with ultra-low volatility, and it was tough to persuade them that that was not necessarily the same as low-risk: you have to look through to the assets being traded.” trading strategies How those assets are traded is important, too, as senior executive officer Omar Kodmani observes. Permal reduced relative-value strategies because they are less liquid and more reliant on leverage – a source of tail-risk in a credit crisis. And although arbitrageurs will eventually regain access to banks’ balance sheets – their trading volumes make them a key revenue source – how long will it take to re-establish confidence? “Do we look for hedge fund managers to be directional?” Mr Sarosy of Credit Suisse asks. “Yes we do. With funds of hedge funds we want flexibility and a manager who will allocate to the appropriate drivers in the market. We prefer those who are more geared towards macro at the moment.” Axa, diversified more traditionally across both directionality and non-directionality, has put its macro and CTA allocations up. But Mr Manser defends fixed income arbitrage: some managers and strategies have fared better than others, he argues, and in any case a good mix of risks remains the best bet. “Some of our strategies will have tail risk,” he says. “To avoid that you will end up with directional strategies and beta in the portfolio – and I’m not sure that that is going to be the right approach.” The moral of all this is that allocators should look for the “flexibility” which Mr Sarosy describes, and expect their managers to be edging towards directionality. However, because that entails loading up on betas (and therefore correlation risks), managers need to have sophisticated risk-management processes in place to model those correlations, especially in stress scenarios. Allocators should avoid immediately dismissing anything with “arbitrage” in the title, and consider the nuances. Finally, allocators should ask how funds of funds are preparing for long-term value plays in distressed illiquid assets. The attention of most will be on mortgage- and other asset-backed securities, but Permal has even launched a Hedge Fund Opportunities Fund, ready to pick up hedge fund allocations that cash-strapped investors can no longer afford. Which distressed managers are being lined-up by your fund of funds? Do they have a view on timing that market? And can their administrator handle those illiquid assets, or the complexity of the instruments that could unlock opportunity – but also cause some real headaches if there are further counterparty credit events? learning curve “We really went through that learning experience in 2003-4, when we grew a lot and came to realize that, although our technology was extremely scaleable, our people-side wasn’t,” says Hans Hufschmid, chief executive officer of independent tech and admin provider, GlobeOp Financial Services. “Today we have 12,000 people in India. We average about 2,000 OTC contracts per day, but a few months back we executed 13,000 contracts for a couple of clients; and the five credit events resulting from Lehman, WaMu, and so on require an additional 50,000 OTC trades - that’s all going fairly smoothly,” explains Mr Hufschmid. “If you invest in hedge funds and you lose money because of the markets, that’s one thing. If you lose money because of operational risk, that’s like somebody stealing from you. You can control operational risk.” The collapse of Lehman Brothers certainly shone the brightest light on prime-broker relations, collateral management, rehypothecation – but your fund of funds should have been scrutinizing underlying managers’ arrangements at least as far back as the Bear Stearns event in March. “There’s only so much you can do, because you are one level removed from the action,” says Axa’s Mr Manser. “But we’ve focused on fully understanding counterparty exposures, on the prime broker and OTC derivatives sides; looking into managers’ repo arrangements and the wider liquidity in the repo market; their cash positioning to buffer refinancing problems, and their cash management; diversifying counterparties, moving away from problematic counterparties.” Still, there is plenty of evidence that people were caught by surprise by Bears Stearns – and again by Lehman. “We’ve never seen the level of relocation of prime brokerage accounts that we saw pre- and post-Lehman,” says Mr Hufschmid. Some 150 of the 1,000 funds on GlobeOp’s platform changed prime brokers – a year’s activity in three weeks. Allocators have to ask how managers’ infrastructure would support counterparty diversity – and novation-demand - in a crisis. “We were able to do that on our platform overnight, effectively, because we have all these pipes with the prime brokers,” Mr Hufschmid argues. “For a fund doing this on their own it’s much slower, error-prone, and less flexible.” Mr Manser admits that funds are still “tidying things up” on collateral-management and credit-risk, so it remains important to get the best transparency possible into the counterparty arrangements underlying managers are putting in place. Is collateral posted daily – and can it be intra-day if necessary? What collateral is eligible? Are you happy for managers to allow rehypothecation, or would you rather have (possibly more expensive) segregated accounts? a comfortable fit “That kind of detail is important to us in choosing a hedge fund manager that we are comfortable to promote,” says Mr Sarosy at Credit Suisse. And for him, the comfort factor largely comes down to track record. “Experience is at the heart of this,” he says. “We have to look at every aspect of the manager’s business before we can recommend them to our clients: from the investment advisors and access to the best funds, to access to liquidity and solid operations. A new manager may spin out from a great firm with a good track record, but the infrastructure they have is new, the bank relationships are relatively new, and we have to ask if we are comfortable with that. The answer is, not necessarily.” Axa’s Mr Manser agrees, conceding that there has been a “hedge fund bubble” that is due for deflation. “We need to be critical about the industry, but we also need to step back and ask, ‘Does that mean that entire model is no longer viable?’” he says. “When the dust settles we will see that the better funds of hedge funds will deliver what they promise – downside protection and participation to the upside.” But to be sure that your house is the one still standing when that dust settles and the hurricane has passed takes full engagement with the risks – both investment and operational – that you are taking. Then you can ask the right questions when the storm clouds gather again.

Paul Sarosy