Hedge Funds: What Happens When the Chickens Come Home to Roost?

[This post is a guest contribution by Niels Jensen*, chief executive partner of London-based Absolute Return Partners.]

My big worry, at the moment concerns what is happening to (some) hedge funds. Clearly, 2008 has been to hedge fund investors what 1992 was to Queen Elizabeth II – Annus Horribilis (see chart 1).

 Chart 1: Selected hedge fund strategies (YTD performance)

Source: The Economist

Merrill Lynch did a study recently, showing that the 30 biggest U.S. equity holdings amongst U.S. hedge funds were amongst the poorest performers in the S&P500. In other words, it is likely that much of the recent sell-off in equity markets around the world can be traced back to hedge fund liquidations.

There is no question that at the present time, hedge funds are downsizing. The problem is to obtain precise data on the phenomenon. If we estimate that the global hedge fund industry controls about $2 trillion of capital, and we assume that 15-20% is going to be pulled out between now and year-end (which is not far from the truth according to our sources), $300-$400 billion must be returned to investors between now and December 31.

Deleveraging continues

That is not the whole story, though. The average hedge fund uses leverage, to the tune of about 1.4 times (see chart 2). This is down significantly from a year ago, but it still means that hedge funds need to liquidate investments of at least $500-$550 billion in order to meet current redemption requests. Moreover, the real number is probably higher because some of the worst performing strategies this year are the ones using the most leverage. Therefore, the real number is more likely $600-$800 billion, and that is a big enough sum of money to put downward pressure on the markets.

Add to this the fact that some hedge funds (mostly the bigger ones) have been selling credit default swaps [CDSs]. A CDS is an insurance against corporate default. The buyer of a CDS supposedly makes money if the underlying credit blows up. I say ‘supposedly’ because the payment is a function of the seller’s ability to pay up. That was why Morgan Stanley (MS) had to be saved, at all cost. MS has been, and continues to be, one of the largest players in the CDS market.

Chart 2: Average hedge fund leverage

There is no way we can establish precisely how many CDSs hedge funds have on their books, but please consider the following: The CDS market is a $50 trillion market (give or take). Before it blew up, AIG (AIG) was one of the biggest sellers of CDSs with approximately $500 billion on its books. The company ran into problems (partly) because it was heavily exposed to the financial services industry, which is already in recession.

Recession in the early stages

The rest of the economy, however, is not yet in recession – or rather, we do not have the statistics to prove it. Corporate defaults are still low, both here and in the U.S., but corporate defaults will go up as they always do in recessions. If AIG, one of the largest and most sophisticated financial institutions could get itself into trouble with barely a 1% share of the global CDS market, what will happen to the sellers of the remaining 99%?

Who ‘owns’ this risk? Is it hedged or not? Is it even possible to hedge the risk, knowing that your counterparty might not be able to pay up? What we do know is that only the larger hedge funds have participated in the practice of selling CDSs. Right now, it feels very good not to be invested in those types of hedge funds (as you may be aware, our focus is on alternative investment strategies away from mainstream hedge funds). I also suspect that the extreme volatility in recent weeks is somehow related to this phenomenon. Investor redemptions are not the whole story.

Conclusion

Several months ago, I pointed out that the world’s stock markets would present several ‘false dawns’ before we could finally declare victory against the bear market. In my opinion, last week’s more upbeat tone was one such ‘false dawn.’  There are three reasons for that:

1. Investors have not yet fully capitulated, and that is a necessary condition for markets to turn around. This is best illustrated by a survey conducted by BCA Research at the end of its two-day investment conference held in New York on October 20-21. Only five or six of the more than 250 people in the room expected the stock market to be lower a year from now. This is not consistent with capitulation! Now, after having said that, it is perfectly normal to experience powerful rallies in the midst of a major bear market, as the sharpest rallies in history have actually been bear market rallies.

2. De-leveraging has a long way to run yet, not so much in the hedge fund community where I suspect that much of the damage will be behind us once we pass the next major redemption hurdle on December 31, but in society as a whole. Governments, banks, (some but not all) companies and, most importantly, the majority of households are more leveraged than is good. I have borrowed Chart 3 below from BCA Research, and it shows total U.S. bank loans as a percentage of U.S. GDP. Unfortunately, the picture would be much the same for many of the European countries. We are now facing a major de-leveraging cycle and it will suppress economic growth and put a lid on the stock market for years to come.

Chart 3: Major deleveraging cycle ahead

Source: BCA Research

3. Whereas I fully agree that the worst of the financial crisis might now be behind us, bear in mind that we have not yet seen the full effect of the economic crisis. We are only in the first or second innings of this recession, and the emerging market story has the potential to wreak further havoc. So do credit default swaps - or something else. Recessions are by nature quite unpredictable. There is one thing I am sure about - just like New Year’s Eve, the more extravagant the party, the bigger the hangover. Prepare for this one to linger for a while yet.

* Niels Jensen has 24 years of investment banking, private banking and asset management experience. He founded Absolute Return Partners LLP, and is its chief executive partner.

Comments

[OldLimey:]

Good analysis. Thanks.

2008 Nov 05 10:36 AM

[Octogenarian:]

Agree that capitulation has not occurred based on sentiments from my circle.

2008 Nov 05 10:52 AM

[Costard:]

Just a few comments regarding your math... if 15-20% is to be pulled out of hedge funds, then 15-20% of hedge fund investments will be liquidated, not 1.4(15-20%). You are conflating percentages with raw numbers. Should investors pull out $200 billion, then yes, hedge funds must liquidate 1.4($200b). Secondly, you are making several assumptions about highly-leveraged hedge funds that need to be backed up: that they are poorly performing, that there are enough of them, with enough assets remaining, and enough extra demand for redemptions in these hedge funds, to allow for an increase in total redemptions by $100-$200 billion - a full 5-10% of total hedge fund holdings. This seems unlikely to me... the most precarious hedge funds are either bankrupt by this point, or they have little value left to redeem.

2008 Nov 05 11:46 AM

[dc1:]

The chickens have come home to roost... and these guys have it coming.

2008 Nov 05 01:05 PM

[Jason Rines...:]

If hedge funds hold $2 T of assets, what year of value are we speaking into, 2007 or 2008? And those assets even while deflated are becoming a bargain to private equity which is where it always should have stayed. Government and banking collusions always end in disasters but the private equity estimated at $4.3 T is ready to gobble it up. However, as Octegenarian stated, I believe we are not a the capitulation stage just yet. Since I can throw my guess around from the cheap seats on the sidelines, I will guess it will be late 2009, early 2010 before I wanted to buy and that is going to be based on seeing what Washington policy (or the lack thereof) is going to be. Right now, government is picking the winners or losers and it's too early to tell in which column a sector is going to fit into.

2008 Nov 05 03:31 PM

[prudentinve...:]

Excellent analysis. Financial meltdown averted, real economy recession only starting and likely to be long and deep.

2008 Nov 05 06:17 PM

[imnotadoofus:]

A lot of the commentary is based on guesswork and not any real fundamental analysis. I agree that hedge funds are about to be an asset class that is diminished in the eyes of consultants and pension plans, and thus money will continue to exit throughout the end of the year for some, but there will also be exodus after January 1, given that funds have 45 days after the end of their fiscal year to meet redemptions, and as many have November 30 as the fiscal year end.

2008 Nov 05 10:03 PM

[imnotadoofus:]

capitulation is occuring as we write and conjure up awful scenarios. But many financials have already had double bottoms and in some cases three bottoms--March, July-August, and September. Each time volume tried up and the benchmarks, or ETFs in the sector, rallied.

2008 Nov 05 10:06 PM

[Pau:]

Several hedge outfits got ahead of the ongoing liquidation trades -- which, of course, provides a floor...

2008 Nov 05 10:21 PM

[Did U Think...:]

Your statement about the bigger the party the bigger the hangover should be thought about long and careful by anyone who expects anything but lower highs and lower lows in 2009. This party really started in 1995 so you know the hangover is going to be a doozy.

2008 Nov 06 02:20 AM

[Marion Cont...:]

The old line, "One way to avoid a hangover, keep right on drinking" - is applicable here. Propping up the economy by increasing the money supply has been (and will continue to be) the game plan for this economy for some time, and has accelerated since the late 90's:

www.nowandfutures.com/...

Sooner or later, the partiers have to make a choice:
Endure the headache and nausea - or else succumb to liver failure.

As much as we wish to avoid pain, the alternative is much less attractive, don't you think.

2008 Nov 06 11:30 AM

[Market Folly:]

Completely agree prieur, have been writing about deleveraging and hedge fund unwinding trades on my blog for a while now (I track hedge funds on my blog). Here's just a few articles I've written on deleveraging: www.marketfolly.com/20...

and hedge fund redemptions which i warned about at the beginning of october: www.marketfolly.com/20...

2008 Nov 07 09:56 AM

[eternitus:]

If a VIX at 80, amateur investors running for the hills with record mutual fund redemptions and a 25% market crash within a month's time is not capitulation, then the market has never capitulated, EVER!, and every "bull market" was simply a bear market rally and stocks are clearly headed to zero. A lot of good points, but all of this capitulation talk is nonsense.

2008 Nov 07 03:10 PM

[themackattack:]

You know, Eternitus has some good points. Really good points. But i think the opposite is true, meaning capitulation hasnt happened. Yes, people pulled out to avoid what most view as a short term situation. When people realize we are at the beginning of a serious consumer led recession, and corporate earnings come back bad quarter after quarter, people willl not "run for the hills", they will simply stop thinking about the stock market. It won't be a part of their consideration, their plans, etc. That, when it happens, is capitulation.. Capitulation is not simply a measure of fear, but fear combined with future hopelessness.

I hope that makes sense.

2008 Nov 07 06:29 PM

[themackattack:]

You know, Eternitus has some good points. Really good points. But i think the opposite is true, meaning capitulation hasnt happened. Yes, people pulled out to avoid what most view as a short term situation. When people realize we are at the beginning of a serious consumer led recession, and corporate earnings come back bad quarter after quarter, people willl not "run for the hills", they will simply stop thinking about the stock market. It won't be a part of their consideration, their plans, etc. That, when it happens, is capitulation.. Capitulation is not simply a measure of fear, but fear combined with future hopelessness.

I hope that makes sense.

2008 Nov 07 06:29 PM