Credit Suisse/Tremont Index Implodes On Bear Stearns Hedge Fund Meltdown

Another day, another hedge fund indexing debacle.

Credit Suisse/Tremont, one of the most popular hedge fund indexers, issued a bit of a revision to one of its indexes Thursday. After reporting on Monday that its fixed-income arbitrage index was up 0.21% in June, CS/Tremont reversed course on Wednesday and said that the index was actually down 6% for the month. Year-to-date returns dropped from positive 3.7% to negative 7.5%.

Oops.

The reason? The implosion of the Bear Stearns (BSC) hedge funds caught in the web of the subprime mortgage meltdown. Those funds did not report returns on time to Credit Suisse (CS), which calculates the CS/Tremont benchmarks. And when they did - poof - the indexes took a tumble.

Every time there's a hedge fund disaster, it seems, another hedge fund index gets dragged into the muck. The S&P Hedge Fund Indexes stopped publication following the Amaranth implosion. And now Bear Stearns difficulties have made a mess of the CS/Tremont benchmarks (and by extension, the composite).

The problem with hedge fund indexes is that they rely on the reporting of individual hedge funds, and a limited number of hedge funds at that. As a result, a single fund implosion can have a major impact on the index, as it did on Wednesday. What's worse, investors in products designed to track these benchmarks are exposed to the same one-off risks. We think of indexes as diversified strategies, but for hedge funds, that's not always the case.

Even when nothing bad happens, however, the actual returns generated by hedge fund indexes often do not reflect the real-time returns of the underlying investments. Nor do the hedge funds themselves.

When hedge funds hold assets that are difficult to price - say, private companies or illiquid securities - managers have to value those assets on a regular basis to produce return numbers. None of these managers value assets in real-time, and many don't even value each asset on a monthly basis. The result is what's known as "serial correlation," when lagging valuation causes there to be undue correlation between this month's return and next month's return ... a "smoothing of monthly returns," to use the phrase of art (http://www.aima.org/uploads/Citigroup.pdf).

This serial correlation is thought to be one of the primary causes of hedge funds' alleged non-correlation to equity markets. In effect, hedge fund valuations (and by extension, hedge fund index valuations) are wrong, with valuations lagging the real-time marketplace. As a result, the return statistics differ from the live equity market returns, because the forces driving the equity market lag in the hedge fund universe.

Wednesday was a special case, when a rare, one-off exogenous event revealed a major flaw in a major hedge fund index. But even when things go smoothly, the numbers churned out by these hedge funds may not be as accurate as they at first appear.

Comments

[Sr. Pessimist:]

"...of hedge funds' alleged non-correlation to equity markets. In effect, hedge fund valuations (and by extension, hedge fund index valuations) are wrong, with valuations lagging the real-time marketplace. As a result, the return statistics differ from the live equity market returns, because the forces driving the equity market lag in the hedge fund universe." -----

Yeah it's not for real. A non-correlation to the equity markets means they're somehow getting something for nothing. Subprime borrowers sign up for a house. They're 100% funded, or thereabouts, and this is 3-6 months of bleed time for the "non-correlation to equity" to look perhaps AAA. The hedge fund leverages on a repackaging of the subprime mortgage and makes it appear as if it's a performing mortgage with $500k of equity behind the performance. There is no equity. 5 cents on the dollar is the going bid. And all these hedge funds with ridiculous returns, I couldn't see how they could just pull that off. Well, they weren't pulling it off. Not really.

That panel put together to detect fraud said 82% of companies are involved in fraud schemes. This means to me that they have a fraud scheme in their own interests, and not everybody even knew what was going on, and they're trying to do something about it. Hedge funds are con operations. That's how they get all that insane money out in Greenwich, Connecticut. Subprime is causing a horrible problem now. The meltdown is going to be way worse. Subprime is great for a hedge fund to advertise to its investors that it manages billions in AAA-rated credit assets. All those gains we saw were from hedge funds. They did all the buying. Like 80% of gains were just hedge funds this whole time, if not more, if the number is right in my head.

Now those unemployed stated income people who signed up for a house go as far as to abandon the house and let mosquito breeding grounds emerge. Then we're getting wind of the subprime meltdown being "way worse than expected." Hedge funds advertise value to investors using fraudulent techniques. It's not a crack addict with disability signing up for a half million dollar house. It's a $500k AAA-rated collateralized debt obligation, and since they're an unregulated private entity, they don't even have to follow any rules. Then they probably borrow on margin, or "leverage," against the half million dollar home the crack addict with no job is living in and smoking weed. Since it's a $500k AAA-rated CDO, somebody could be convinced fund it. But let's not call it "borrowing on margin." Let's call it "leveraging the bet." No, let's call it a "leveraged investment." After all, we've attained several billion dollars of AAA-rated CDO equity, so let's leverage against that and place a billion on these stocks over here, and invest a billion for "borrowing voting shares" on the board of a corporation. Then let's have the corporation buy out the companies under those stocks at the price we set.

But now they can't leverage any more bets and produce those billions in returns, because subprime is a nasty word. It turns out that crack addicts buy more crack, but don't increase the equity in the economy. This means the $500k in AAA-rated CDO equity is really a non-performing security. This means the professional and institutional investors got a little money when they put investments in to acquire the AAA-rated billions in worth, but they're losing their principle, down to 5 cents on the dollar, of all that easy money that all of the sudden dried up at 0-5% original value equity (explode). The con-artist hedge fund managers made some handsome salaries. Corporations bought other corporations. Hedge funds have near 0 equity value now. And all those stock market gains we saw driven by hedge funds were just written on paper, and not really even that. Those gains were artificial. They never happened.

So those who believe in a free lunch got a free lunch. At the expense of those poor underpaid workers we have all around. The working poor, we call them. Now it's time to pay for the free lunches people had. 14,000 barrier was crossed. Let's see. The market might hit 7,000, but that's assuming bad things continue. I said 7,000 a year ago. I was wrong, but because of the gains we saw. It could probably go below 10,000. That's not beyond my imagination.

2007 Jul 22 10:53 AM

[Sr. Pessimist:]

Oh, and don't forget the house priced at $500k was never truly worth more than $300k on the real market. It was just an inflated price to make it look like it was worth more than it really was.

2007 Jul 22 11:01 AM

[Sr. Pessimist:]

Hey- how do you like that? Up to 82% of these behemoth hedge funds were really just massively-conspired, high-profile con operations!

2007 Jul 22 11:05 AM