All times are London time
Some interesting responses to the FT’s reports on May 2, that the FSA claims that hedge fund gearing has decreased (Related) , and on May 3, that the New York Fed suggestion that there is no close correlation (Related) between hedge fund returns before and after the 1998 implosion of the LTCM fund.
Among them comes a punchy letter (Related) from Janet Tavakoli, president of Tavakoli Structured Finance, who writes: “I believe it was Winston Churchill who said we must alert somnolent authority to novel dangers. But in this matter, authority seems complacent and the dangers are not novel.”
In its report (a survey of prime brokers, the main lenders to hedge funds), the FSA produced numbers from a partial survey of hedge funds and discussed “average” leverage, “thus highlighting the well known flaw of averages”, says Ms Tavakoli. “If a swimming pool’s average depth is four feet, but the deep end of the pool is eight feet, non-swimmers are presented with unacceptable risk. The average would suggest non-swimmers can safely use the pool, but a drowning man finds out the hard way that the average doesn’t contain information descriptive of the risk.”
The NY Fed, meanwhile, used data to examine volatility and correlations, neither of which are of much use in a crisis “when correlations deviate from historical measures and even approach one”, she notes.
Even today, “one should consider that hedge fund returns are anything but independent”. Hedge funds invest in the global markets along with other investors, albeit hedge funds may be more creative, more illiquid and may employ more leverage.
“Tavakoli’s law” states that if some hedge funds’ returns soar above market averages, then others must crash and burn, says Ms Tavakoli. “If one accepts that passive investors are indexed and reap average market returns, then active investors that reap extraordinary returns above the market average are offset by active investors who experience extraordinary losses in aggregate”.
Sure, the current situation may be different from the LTCM scenario, “but it may be even more alarming, not less alarming”, she says. Why? “Due to the use of structured products and derivatives, hedge funds can take on hidden leverage above and beyond that which can be explained by polling prime brokers.”
Furthermore, “illiquid structured products will experience a classic collateral crash when hedge funds try to liquidate these assets to meet margin calls or collateral ‘cures’.”
Since 2000, assets invested in hedge funds have more than tripled to around $1,500bn, Ms Tavakoli notes. “While on average leverage may appear manageable, some hedge funds – Amaranth, for a recent example - employ high degrees of leverage.” A potential source of a “great unwind” arises from a trigger event affecting highly leveraged hedge funds, and another potential source is systemic risk that effects a larger cohort of hedge funds.
“Many hedge funds are not highly leveraged, and they will weather the storm. But the explosion of hedge fund investments in illiquid assets combined with leverage currently pose a greater risk to the global financial markets than at the time of the LTCM debacle.
Comments
Absolutely right about “Statistical Misrepresentation”.
While it may be that some hedge funds are not too leveraged currently, the performance trap will induce more and more to consider higher leverage just to stay in the race. In a trending market ,the higher the leverage on a correct position, higher the returns reletive to equity.
Dr. A S Johan provides Hedge Fund, Private Equity and Venture Capital related strategic management consulting services to institutional and private high net worth investors under the personal service mark of A S JOHAN GMS.
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