Thursday, December 18, 2008

Funds of Hedge Funds Facing Extinction?


Wall Street extended its losses Thursday, as a negative ratings outlook on financial and industrial powerhouse General Electric Co. shook an already fragile investor psyche and sent stocks tumbling:
After moving within a narrow trading range for much of the session, the Dow Jones industrial average dropped about 220 points. The broader Standard & Poor's 500 index lost more than 2 percent.

Stocks struggled to find a direction in the early going Thursday as investors sifted through a number of economic indicators, including more layoffs and dismal earnings forecasts.

But a negative ratings outlook on GE from Standard & Poor's added further pressure on the market.

The ratings service lowered its outlook on GE and its GE Capital finance arm to negative from stable. S&P affirmed their Triple-A ratings, but said there is a one-in-three chance they could lose them because of the ongoing financial struggles at GE Capital.

GE shares fell $1.43, or 8.2 percent, to close at $15.96.

At the same time, energy stocks tumbled as oil prices plunged. Crude briefly dropped below $36 a barrel Thursday on worries of a drastic pullback in energy spending, even after a record production cut from OPEC earlier this week. The price settled at $36.22 a barrel in trading on the New York Mercantile Exchange.

Oil prices have been on a downward march since reaching a high of near $150 a barrel in July.

"The fear is that if oil does fall down to $25 or $30 a barrel, that could indicate that the economy is even weaker than market perception and that obviously is negative," said Peter Cardillo, chief market economist for Avalon Partners.

So much for collapsing volatility. One interesting comment that I received after yesterday's comment on volatility was from Bruce Friesen of Global Investment Solutions:

Volatility measures start going down as you start to work off the huge drop in prices out of the math. Additionally as your article mentions volumes are dropping which also reduces volatility. But in my opinion volatility will not truly be reduced until brokers run books of inventory again. Which I do not see happening to date.
Fair point and I agree with Bruce that as long as brokers do not provide liquidity for the markets, volatility will remain high. But Bruce also agreed with me that the volatility will mostly be concentrated in equities and corporate bonds whereas in government bonds and currencies, volatility will decline.

As far as oil, the plunge in price reflects the global recession. It also reflects the fact that speculators, including pension funds, are selling their stakes in oil futures realizing that commodities are risky for pension funds.

Speaking of risky investments, it is now coming out that pension funds in the US and especially in Europe were exposed to the Madoff scam mainly through funds of hedge funds:

One of the most striking aspects of the Madoff affair is that the US victims are mainly private individuals and foundations. Professionals mostly steered clear. Many smelled a rat.

In Europe, where Mr Madoff was largely unknown, dozens of supposedly sophisticated institutions poured billions of clients’ money into his pockets.

Many of these were so-called funds of hedge funds, which select individual hedge fund managers for investors and put them together into diversified portfolios.

They charge hefty fees, traditionally 1 per cent of assets under management and up to 10 per cent of profits. But they justify this partly on the basis of the painstaking due diligence they carry out. Oops. If they can’t spot a Madoff, despite all the red flags that warned off the American pros, what is the point of them?

One consolation for the likes of Man Group’s RMF business is that they are in good company. Industry insiders say that many leading European funds of funds made the same mistake and that Geneva’s hedge fund cluster is in a complete panic about it.

This is the last thing the funds of funds business needs. The model — and the fees — were already being questioned after a flood of redemptions this year.

Many hedge fund managers have been predicting consolidation among the funds of funds as bigger operations take advantage of the economies of scale — to offset pressure on fees — and investors move towards a few well-known names.

It is likely that the Madoff affair will accelerate this process, helping those funds of funds that are part of larger asset management groups, such as BlackRock and Blackstone.

Man Group was in a position to be one of the consolidators, so its failure to avoid the Madoff bear trap is a particular blow.

It could be worse. Its fund of funds has only 1.5 per cent of assets with Madoff and even if that is written off entirely it is down only 13.9 per cent this year, better than the industry average of 20 per cent. Still, it’s hard to think of a bigger gift to its more careful rivals.

Bloomberg reports that Man Group, the largest publicly traded hedge-fund manager, has about $360 million invested in two funds linked to Bernard Madoff.

Reuters reports that Swiss private bank Union Bancaire Privee (UBP) was quoted on Thursday as saying that it had a $700 million exposure to the alleged $50 billion securities fraud by Madoff:

The Geneva-based bank that invests in funds of hedge funds denounced the "massive fraud" but said its exposure was less than 1 percent of its portfolio, which was some 126 billion Swiss francs ($117.2 billion) as of June 30.

Christophe Bernard, responsible for UBP investment policy, told the daily Le Temps: "The exposure of the accounts under our discretionary management mandate and our funds of alternative funds is 700 million dollars, or 800 million Swiss francs."

"The financial solidity of the bank is not affected and remains top flight," he added.

The daily Le Temps, citing unnamed banking sources, had previously estimated UPB's losses at some 1 billion Swiss francs.

The bank did not have any investments of its own with Madoff, whom it had last visited in late November, according to Bernard.

UBP had done its "due diligence," fulfilling its fiduciary duty, and had had faith that the SEC's surveillance was strict.

Dinvest Total Return, its main fund of alternative funds, lost 3 percent, bringing its loss to 21 percent for the year, he said.

Overall, its alternative portfolios hit by the alleged fraud had exposure of 2 to 5 percent, he said.

"On the other hand, we have reduced significantly the weight of hedge funds in the portfolios of our clients," he added.

Too little too late. Why didn't they protect their clients before by not investing in this scam?

Another Swiss fund of hedge funds, EIM, lost $230 million in the Madoff scam. Arpad ‘Arki’ Busson, EIM's chairman and founder, told Bloomberg that the Ponzi scheme couldn’t have been carried out alone:

“For the amount of money and number of accounts, it’s practically impossible that he was doing this alone,” said Busson, whose $11.5 billion fund of hedge funds had about $230 million invested with Madoff. “What’s mind-boggling is the amount of assets and the amount of time he was doing it.”

EIM, which manages accounts for mostly institutional clients, invested with funds that had managed accounts overseen by Madoff. EIM will likely write down its stake to zero, Busson said. Madoff was arrested Dec. 11 after he told his sons that Bernard L. Madoff Investment Securities LLC was a fraud, according to the U.S. Securities and Exchange Commission.

“There’s only so much due diligence you can do, and in hindsight you always wish you could have done it differently,” Busson said in a telephone interview. “Catching a fraud like this is practically impossible.He seemed like a very experienced, knowledgeable and trustworthy man, like the best con artists always are.”

Aren't the best con artists always experienced, knowledgeable and trustworthy men? And to claim that this fraud was practically impossible to detect is ludicrous given all the red flags that were raised in Madoff's fund.

So where does this latest fallout leave funds of hedge funds? Some funds of funds like Persistent Edge in Asia, have managed to preserve capital. According to Finance Asia, all of Persistent Edge’s funds are up in 2008. Now the funds of funds house is setting its sights on helping China Investment Corporation manage its money:

Persistent Edge has been Asia’s most successful fund of hedge funds provider in the past three years. During the good times, they outperformed the rest of the funds of funds market by a considerable margin, and now, remarkably, in the downward cycle they have succeeded in preserving capital at a time when global funds of hedge funds are down nearly 20% on-average.

Now, it are setting its sights on helping China Investment Corporation (CIC) manage its money. CIC has not had a good year with its cross-border investments – and that’s putting it mildly. It’s the fact that they have passed the acid test of 2008 that is now prompting Persistent Edge to think laterally about how it could participate in the management of sovereign wealth money.

“We have now proven through the last few years that Persistent Edge has been successful in getting returns in all types of market conditions," says Eric Xu, the managing director of Persistent Edge’s Hong Kong office and the chief risk officer. “That contrasts with the experience of China’s sovereign wealth investments this year. So we hope we can offer our help in advising them constructively in the future.”

Any collaboration with CIC would not likely see sovereign money being credited to Persistent Edge’s existing funds, but instead constitute an advisory arrangement with the view to investing money actively in hedge funds.

Running through the funds that they currently offer, the flagship is the $500 million Persistent Edge Asia Partners Fund, which was up 1.8% at the end of November. Second, the $200 million Persistent Edge China Partners Fund, which is up 1.3% for the year, and third, the $120 million Persistent Edge Global Partners Fund, which is currently up 0.2%.

In 2007, the same three heavy-hitting funds produced stellar returns of 47%, 76% and 30% respectively.

The secret of their success has been difficult for competitors to decipher, and before you jump to a false conclusion, Persistent Edge is audited by Ernst and Young, and all of its underlying funds employ major prime brokers and are audited by a big four accountancy firm.

Some speculated that their success in previous bull years was due to leverage. But Persistent Edge says that’s not the answer, and it doesn’t use leverage. Instead it attributes its performance to being swift at moving in and out of themes at the right time. Until late-2005, it was overweight in Japan, then switched into long-bias China for 2006 through to the autumn of 2007. Then it moved out of its long bias China funds into trading oriented China funds with net exposure parameters of plus-to-minus 20%, typically funds that would use ADRs and H-shares for shorting purposes.

Before taking profits, Persistent Edge waits until any penalty for redemptions has passed by. However, Persistent Edge won’t invest in funds that demand lock-ups and looks for monthly liquidity. So if there is any growth in a trend of hedge funds imposing lock-ups in order to prevent investors accessing and moving around their money, then Persistent Edge won’t be investing. On the other side of the coin, Persistent Edge offers different liquidity depending on its investor terms, typically though their standard terms offer quarterly liquidity.

Persistent Edge has a pipeline of $200 million from new investors lined up for 2009 and plans to keep the same investment themes, but may weight their allocations differently. There are concentrations at the top end of some of the funds, caused by organic growth within those hedge funds. The new investor funds flowing into new hedge fund investments will serve to partially dilute concentrations. If there are still concentrations evident, then Persistent Edge says they will alleviate those by taking chips off the table.

The hedge funds that comprise their current portfolio are not public information, in order not to lose their edge on their competitors. However, their investors know their identity, and so does AsianInvestor (though we promised to keep it quiet).
I will warn you again, if it looks too good to be true, be careful! Also, who cares if they are audited by a big accounting firm? You need to conduct a thorough due diligence with operational risk experts to assess any hidden risks of these funds of hedge funds.

Not all funds of funds see a bleak outlook. According to Standard & Poor's Fund Services, funds of hedge funds are optimistic on buying opportunities in hedge fund strategies despite suffering their worst year ever:

Randal Goldsmith, lead analyst at Standard & Poor's (S&P), said despite high losses and redemptions, managers such as Theta Capital Management were upbeat on long-term prospects.

However, in the short term, fund houses acknowledged forced selling would continue, creating even more value in its wake.

Charles Hovenden, manager of the Absolute fund, saw a "once-in-a-lifetime" chance for convertible arbitrage investors, with powerful arguments next year for distressed assets and equity hedge in the US and Europe.

Karen Kisling, manager of the Benchmark Alternative Opportunities fund, agreed convertible arbitrage and deep value long/short equity represented buying opportunities.

Sub-prime, asset-backed securities and agency mortgage markets also constituted an attractive medium-term position.

S&P added renowned hedge fund manager John Paulson had launched the Paulson Recovery fund for distressed assets and started buying sub-prime assets after making money off shorting them.

However, it is still unknown which time will prove the most profitable to invest in distressed assets. Fund of hedge fund managers have been looking at openings in the strategy for much of the last year.

There is also a concern that distressed, illiquid assets may be accompanied by long lock-up periods in which funds of hedge funds will be unable to withdraw their investments.

Despite their optimism, I warn investors to select their funds of hedge funds very carefully (if they opt for that route). This is especially true now that hedge funds are closing at a record rate:

A record number of hedge funds went bust during the third quarter, a report showed Thursday, as shaky markets and tight credit drove investors away from risky investments.

Hedge Fund Research, a Chicago-based information company, said the number of hedge funds liquidated in the third quarter rose to 344, which is more than three times the 105 liquidations in the third quarter of 2007. It's also 77 more than the previous record of 267 liquidations in the fourth quarter of 2006.

The data also showed that 693 hedge funds were closed in the first nine months of the year versus 409 in the same period last year. That's an increase of 70% and represents nearly 7% of all hedge funds, according to HFR.

"The hedge fund industry is currently experiencing a structural consolidation that mirrors broader trends across the entire financial industry," HFR President Kenneth Heinz said in a statement. Stock market volatility and a lack of available credit "increased the challenges for both funds and investors," he added.

Indeed, in the third quarter, the number of hedge funds closing shop exceeded the number of funds launched for the first time since HFR started tracking this data in 1996.

At this rate, hedge fund liquidations are on track to reach 920 for the full year, the report said. That would outpace the 563 liquidations last year, and could top the previous record of 848 in 2005.

This year has been brutal for many fund managers as the financial crisis has unfolded and investors have fled risky investments.

Hedge funds have been flooded with redemption requests in recent months as the crisis has exploded and investors have asked for their money back to cut losses or pay back debt.

The third-quarter was a particularly brutal, with the Dow Jones industrial average plummeting nearly 25% from October to November.

"Risk tolerance is at a historical low," Heinz said. "Investors are not even distinguishing between a fund that's up 10% and one that's down 10%. Both facing redemptions."
So for all those pension funds that continue to pile into funds of hedge funds, make sure you are carefully selecting your funds of hedge funds by focusing on those that align of their interests with those of their clients (ie., they are not just huge asset gatherers) and make sure they conduct rigorous operational and risk management due diligence.

But whoever you choose, keep in mind that in this environment, most funds of hedge funds will be reduced to road kill.

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