A 10-Year Retrospective of Hedge Fund Risks and Returns

Hedge funds have significantly contributed to the evaporation of the essential capital equity value of large financial institutions[1], first banks and then all other industries' corporations, throughout the managing of their financial statements from the mid nineties to now. Hedge funds created profitable offshore entities generating excessive significant returns over time without caring about their risks. From insufficient risk management, back and middle office infrastructures and technologies, or qualified conscientious staff, hedge funds have also contributed to the downgrading of financial assets and to the overstatements of their actual values, causing financial losses across most sectors and the world.

At large, in this short article, we will briefly see that their high cumulative returns correlate to the high write offs and write downs of large banks’ assets currently experienced since the summer of 2007, but truly experienced on banks’ books since November 2002[2].

With cumulative returns of at least 300% since 2000 across most strategies, regions and capacities (according to all indices), hedge funds pocketed the returns without managing the risks, and banks are starting to lose on the risks they take by servicing them without knowing their risks, such as exact intraday exposures across all products, all funds, all traders' portfolios, all strategies, all counterparties, and all maturity buckets. It is as if risks no longer existed and returns were cumulatively pocketed by tweaking valuations upside by 1 or 2% monthly since their inception, generating thus at least 12% but mostly 20 sometimes 30% per year since 2000. The indices also show that in 85% of the months across these past years, hedge funds returns are positive.

Since the beginning of this century, banks created their own in-house hedge funds in their asset management branch to shift capital towards hedge funds to avoid risk management, technology burden and regulatory charges that would otherwise exists on traditional business lines such as pure equities, debts, commodities and foreign exchange products (see www.bis.org). By having their own hedge fund branch, banks underpaid regulatory charges such as Sarbanes, Basel Capital Standards, or MidFid and pocketed significant returns directly correlated to the managers’ salaries.

The phenomena became so out of hand that regulators had so say over these globally integrated shells across various countries at once. Hedge funds quickly became very lucrative for banks because on one hand, with the asset management branch, they were cheap and they generated high management, incentive fees, and on the other hand, with the prime brokerage branch, they generated high returns on high volume of trades processing and other services. Prime brokers became service providers and administrators too; so they not only benefited from the high voluminous fees from trade processing, clearing and confirming or outsourcing of risk management services, or simply accessing competitive prices and positions of funds, but they also gained on high fees generated by the funds they manage throughout the asset management branch, allowing them to trade against competitive hedge funds clients of the prime brokerage branch. In essence, the banks became their own counterparties, issuing their own credit lines, while servicing and managing them at the same time.

For instance, according to Lipper 2006-2007[3], HSBC (HBC) reported administrating about 19% of the global market shares of hedge funds. Citigroup (C) covered about 5% of the global administrations while operating their own hedge fund. Fortis exposed with about 7% of the total global market share in hedge fund administration and suffered profit losses of 45% in the first quarter of 2008 with 2.31 billion USD. Goldman Sachs (GS) also covers 12% for global hedge funds greater than 1 billion USD capacity. Goldman Sachs services about 20% of the total market share in prime brokerage outsourcing of hedge funds while managing its own alpha fund, which lost about 30% of its valuations throughout 2007 and managed to raise about 7 billion USD to continue operating[4]. UBS (UBS) is also a major player at providing 8% of the global prime brokerage services while having its own hedge fund branch and suffering significant write offs. Related to bad trades and downgraded exposures from mortgage securities and subprime, UBS lost at least 14 billions USD in 2007. Morgan Stanley (MS), which owns a very large asset management hedge fund branch worth at least 20 billion USD as of 2006, also covers about 27% of the global market share in hedge funds prime brokerage services and is the largest global player as of beginning 2007. Bear Stearns (BSC), who suffered losses of two large hybrid credit derivatives funds worth about USD 5 billion as part of its asset management branch in May 2007, also covers about 23% of the total global market share in prime brokerage services of hedge funds.

Another part of the risk is that most are audited by the very few auditing firms who are highly involved in conflict of interest with on one hand the banks and on the other, the funds. For instance, in 2006 and 2007, Ernst and Young alone globally owned about 34% and 32% of the total market share of all hedge funds audits, including banks’ funds and funds themselves. In the same years, PriceWaterHouseCoopers also owned 29% and 32% of the global audits for banks’ in-house hedge funds and hedge funds alone. The high risk concentrations being “reviewed” by auditing firms form is in itself a significant danger for the financial industry because there is very little independence in the validations of risks incurred by all interactors, because of being so very few.

Most of all industries are now involved with hedge funds to maximize pension funds, retirement funds, educational fellowships of employees, and medical benefits just because they were more profitable and still continue to be apparently as banks offer only a few percent on savings. All banks come right after CITCO being the largest administrator globally and basically covering their illegitimacy. In the prime brokerage sector, banks have been largely exposed to hedge funds throughout the processing of risk management reports, the clearing of individual trades among other services without knowing the risks of their underlyings.

Hedge funds have illegally ripped off the true value of initial capitalism and global enterprise assets with too many innovative techniques without the risk monitoring, the compliance expertise and the infrastructural technologies. Players have been quick to generate returns without properly assuring all sides of the trades’ risks. As a consequence, assets are currently overvalued from cheap infrastructures and low risk monitoring. Hedge funds greatly benefited from insufficient regulations, risk management, infrastructures, and technologies because budgets focused mainly on returns and correlated managers compensation schemes.

The exponential development of hedge funds have come with many challenges and problems for the greater global financial system. As opposed to banks, the hedge fund model tends to focus on managing high asset capacity with lower staff numbers to surround what became an inadequate reasonable management of all risks. Hedge funds are purposely complicated in terms and formulas to deceive investors and the general public.

As a result of prioritizing on trading first and risk manage second, many global market failures occurred with the following chronological events order.

In 1998, Long Term Capital Management went bankrupt for being overleveraged by 26 times its capacity.

In 2002, the Securities and Exchange Commission recorded a significant number of hedge fund cases, most notably with the failure of Beacon Hill, a mortgage market trader who mishedged and did not have adequate risk management standards.

In 2004, the global market failure of hedge funds was 15%, in 2005 20% and in 2006 25%.

Then, significant institutional scandals started to occur. For instance, in the fall of 2006, Amaranth hedge funds went bankrupt and evaporated about USD 9 billion. Bear Stearns lost at least 4 billion USD from the two failed credit derivatives hedge funds which lacked liquidity and had to call for greater credit risk limits. Goldman Sachs' Alpha fund lost about 35% of its total asset valuations throughout 2007 alone.

Throughout 2007, the subprime market started to demolish the financial industry with cumulative mounting write downs evaluated to 500 hundred billions euros as of December 2007. This exposure is more or less the equivalent of the prime brokers’ exposures to hedge funds evaluated to 463 billion USD as of end of 2005. Many of the losses go unreported because of the lack of legislative boundaries surrounding the 5 trillion dollar fund industry spread out across many countries throughout various trading schemes. Many funds and banks’ offshored branches find them squeezed with lowering eroding assets on their portfolios between two currencies or two counterparties or term structures of assets. Many write downs are unexplained or are explained vaguely by devalued subprime assets which had not been monitored properly and which turned out to be cheap due to low risk management standards or lack of risk management at all.

As of December 2007, Merrill Lynch wrote down at least 1 billion USD, Citigroup depreciated assets by 16 billions USD and wrote down 15 billion USD, Bank of America (BAC) erased 3.3 billion USD, Morgan Stanley wrote down 3.7 billion USD, HSBC 12 billion USD, UBS 10 billion USD, Northern Rock (NHRKF.PK) wrote down 38 billion USD and caused significant illiquidity dryouts in the UK market, Société Générale (SCGLY.PK) depreciated 230 millions Euros of assets on their statements, Calyon depreciated 850 millions euros of assets, Natixis (NTXFF.PK) reported 1.5 billion euros of write downs and depreciated or substracted assets valuations worth 408 millions USD[5].

By November 2006, the subprime market in the United States started to make public announcements of its mortgage market failing state, which rippled into a global suffocation of liquidity by the summer of 2007. This was coupled with prime brokers' insufficient overnight liquidity to maintain credit limits due to depletion of collateral asset valuations of large hedge funds holding mortgage trades among other hybrid credit derivative structures. And this illiquidity failure of all banks is mainly financed by the Federal Reserve and other global Central banks who continue to inject billions in the systems and who tend to lower interest rates, while in fact global citizens don’t gain anything on their savings and inflation is truly rampant on their day to day expenses like gas, oil and daily goods.

Hedge funds give the illusion of being ideal in spreading wealth, but they showed and proved that they failed to allocate towards altruistic causes and mostly principally refused to establish in unsafe emerging markets. They caused geopolitical dislocations and turmoil and exacerbated breakage of generational wealth as they supposedly manage pension funds, retirement funds, social security budgets, and university endowments. Because of them, the global financial system is truly at risk and we are only seeing the beginning of their mismanagements.

Notes:

The above is an excerpt from my manuscript, which seeks a sponsor and a publisher. It contains about 250 graphs of hedge funds returns and risks since 2000 and all risk exposures of hedge funds with banks, auditors, and others. With this report, investors will know exactly which entities are highly or lowly involved with these structures.

[1] ‘Global Unhedged Hedge Funds’ January 2007, IncisiveMedia, Armelle Guizot

[2] Asset Alliance Capital Management, Research of the Role of Hedge Funds and the Global Economy, Armelle Guizot (July to November 2002). Interview of a dozen hedge funds.

[3] www.hedgeworld.com: Fall 2007 and Spring 2008

[4] Hedgeweek daily comments: Fall-Winter 2007.

[5] Financial & Economic pages of Paris Match: December 24th 2007.

Comments

[Regulate]

Thank you so much for this expose which has been way overdue. The lack of regulation and transparency in the hedge fund industry is obviously weakening the economy and leaving investors exposed to exploitation and fraud.

[johnthebear]

I hope to see your published manuscript soon. I would love to see all of those graphs and charts that would make the hedge fund more understandable. Thanks for your article

[Informed]

Wow! Thank you for this misguided hedge fund fear mongering expose. You do realize that hedge funds are like any other entrepreneurial exploit? Take a look some time at the number of business that fail on annual basis and you will be shocked to find out that hedge funds do quite well at a failure rate of only 25%. Also, just like any other business, hedge funds do not exist to make us feel warm and fuzzy on the inside they exist to make money even if it is at the expense of some large banks who can't figure what is or is not on their own balance sheets.
Good thing its all the fault of the hedge funds and not the people who do not do any research and due diligence on who they are giving their money to. If you take a look at a majority of the blow-ups its all in heavily levered funds (Peloton, Bear Stearns, LTCM...). And not just 2x's levered but 20-60x's. Peloton's offering memo stated they carry 20-60x's leverage. Any investor with half a brain would look at that and immediately file in the circular bin, at least I did. Although, this is a typical American response (I am an american) push the blame on to someone else as opposed to taking responsibility for your own decisions.

[User 164069]

I always rated seekingalpha.com high on quality of content and editing - but this article gets an 'F' on both counts. The author seems to have very little understanding of how hedge funds, investors, banks, prime brokers and administrators operate, and also what is driving the current crisis. The fact that Fortis, Goldman, Morgan Stanley, Bear Stearns operate their own hedge funds and also have administration and/or prime brokerage operations has nothing to do with their recent losses and write downs.

All in all, a very poor effort.

[BlueFrog]

I'm not quite sure how the author has made the link between the questionable sub-prime lending practices of banks and the investment practices of hedge funds. And just exactly how much does a portfolio have to return before it become "excessive" whether onshore or offshore? I suspect that this diatribe against the hedge fund industry is a self-serving rant designed to drive investment managers to her risk management consulting practice. Given France's political and economic contributions, I would line the birdcage with this piece.