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Hedge fund risks worst since '98 crisis, Fed says

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NEW YORK (Reuters) - Hedge funds may now pose the biggest risk of a crisis since 1998, when the implosion of Long-Term Capital Management threatened the global financial system, the New York Federal Reserve said on Wednesday.

The statement represented the bank's sternest warning to date over the possible fate of the $1.4 trillion industry.

"Recent high correlations among hedge fund returns could suggest concentrations of risk comparable to those preceding the hedge fund crisis of 1998," according to a paper written by Tobias Adrian, capital markets economist at the central bank.
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Back in 1998, the New York Fed helped bring together Wall Street tycoons who eventually cobbled together enough funds for an unprecedented $3.6 billion bailout.

The LTCM crisis was all the more shocking to investors because of the individuals involved, regarded highly for their market savvy and mathematical prowess.

But with the crisis averted, the hedge fund industry bounced back with a vengeance, increasingly rapidly over the last decade in both size and scope to an estimated $1.4 trillion.

Hedge funds, investment pools that are aimed primarily at wealthy investors and institutions, have been very lightly regulated, facing only vague registration requirements.

Their sheer immensity has raised some red flags from policy-makers, with New York Fed President Timothy Geithner among those sounding repeated warnings about the need for cautious lending.
The Fed's latest worry arose from what it described as a rising correlation between the actual returns of hedge funds, which could point to similar trading strategies that excessively concentrate risk on too few market positions.

"Similar trading strategies can heighten risk when funds have to close out comparable positions in response to a common shock," the economist Adrian wrote.

Still, many officials including Geithner have shied away from calling for explicit regulation, arguing instead that the large banks who lend to hedge funds should police themselves to make sure no one lender gets in too deep.

Hedge funds borrow large sums of money in order to take aggressive bets on financial markets. Many operate heavily in the derivatives market, estimated at around $17 trillion, raising fears about possible future shocks.
 
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Years ago, the New York Times famously referred to financial instruments used by hedge funds as "exotic and risky." Today, hedge funds have truly emerged as a legitimate and increasingly stable investment vehicle.

The hedge fund industry has exploded in size with global hedge fund assets valued at more than $2 trillion this year, according to a survey released by publisher HedgeFund Intelligence. Even with its enormous growth and influence, very few investors truly understand how hedge funds work and how they achieve "alpha" or returns that are independent of market movements.

According to a new Spectrem Perspective report released earlier this month, just 18 percent of affluent investors, defined as having more than $500,000 in investable assets, say they understand hedge funds. This is an industry that every business major needs to understand considering their massive impact in capital markets.

Long Term Capital Management and Amaranth Financial Advisors should not be the only hedge funds you can think of when a professor asks for examples of hedge funds in class discussions. D. E Shaw, Citadel, Perry Capital, Man Investments and Renaissance Technologies should be at the tip of the tongue.

In brief, for every overzealous hedge fund trader out there that blows through $6 billion on a bad natural gas bet, there are hundreds of others that consistently deliver positive returns irrespective of market conditions, while reducing volatility, risk and preserving capital.

Hedge funds are often referred to as "absolute return strategies," which means that many are designed to seek positive returns in most market conditions.

The term 'hedge fund' is an industry term, not a legal term; thus, there is no single definition, but perhaps the best unofficial definition was given by former SEC Chairman William H. Donaldson. "The term 'hedge fund' is undefined, including in the federal securities laws. Indeed, there is no commonly accepted universal meaning. As hedge funds have gained stature and prominence, 'hedge fund' has developed into a catch-all classification for many unregistered privately managed pools of capital. These pools of capital may or may not utilize the sophisticated hedging and arbitrage strategies that traditional hedge funds employ and many appear to engage in relatively simple equity strategies. Basically, many 'hedge funds' are not actually hedged, and the term has become a misnomer in many cases."

If the Amaranth collapse left anyone with the notion that hedge fund managers love taking risks, it must have been those who don't know much about hedge funds.While Amaranth might only be an aberration that confirms the rule, it is important to understand that most hedge funds use derivatives only for hedging and many funds have models that are not leverage-driven.

Most importantly, what differentiates hedge funds is their chosen strategy and since they often attempt to neutralize the effects of market movements, their returns are highly dependent on the skill of the manager.

In addition to the 30 percent jump in hedge fund assets from January 2006 to more than $2 trillion in 2007, there are more than 9,000 hedge funds, 351 of which manage $1 billion or more. The most interesting aspect is the increase in types of investors who have begun to invest steadily into hedge funds.

Increasingly, new money is coming from institutional investors like pension funds, endowments and more than $1 trillion channeled through funding from hedge funds, which allocate clients' assets to a range of outside managers, according to HedgeFund Intelligence.

Hedge fund assets worldwide amount to about a tenth of the $20.5 trillion managed by mutual funds in Europe and the U.S., according to Bloomberg. Considering that last year, the average hedge fund was just 5.3 years old, this is an industry with unlimited growing potential. The Bank of New York predicts that institutional assets in hedge funds could nearly triple by 2010.

Europe was the fastest-growing region in terms of hedge-fund assets last year, assets that grew roughly 40 percent to $460 billion. And in case you were wondering, New York is the hedge fund capital of the word accounting for 41.5 percent of assets, followed by London and Connecticut.

On average, between 18 and 22 percent of all trading on the New York Stock Exchange is hedge fund related and between 30 and 35 percent of all trading on the London Stock Exchange is hedge fund related.

Since Fortress Investment Group's public offering minted a few billionaires, the buzz on the street is all about who will be the next hedge fund to go public. Avenue Capital and Perry Capital, which have already branched into private equity and real estate, are at the top of the rumor mill.

Kenneth Griffin's Citadel Investment Group, which has already staged a bond offering, is also considered a top crop for a potential offering. In a recent article by Jenny Anderson in the DealBook section of the New York Times, titled "Will a hedge fund become the next Goldman Sachs?," Anderson asserts, "Citadel has elements of an investment bank disguised as a hedge fund, minus the investment bankers."

There is a growing sentiment that it is now almost impossible to find a pure hedge fund that sticks to a specific niche. With so much capital, the big players are diversifying into other avenues. SAC Capital, a $12 billion Connecticut shop run by Steve Cohen, just joined Kolberg, Kravis and Roberts (KKR) in a $3.8 billion bid for an education company.

On another gamut, hedge funds are drawing big names; Stephen Feinberg's Cerberus Capital counts Dan Quale as a part of its team and former Treasury secretary John Snow as chairman. Chelsea Clinton recently joined Avenue Capital's team.

One of the more interesting funds in the industry is the $24 billion shop by the name of Renaissance Technologies run by former math professor James Simon.

This shop is filled with a group of Ph.Ds that use top secret algorithms that are understood only by insiders and works exceptionally well. The hedge fund industry is so hot that private equity firms, such as the Carlyle Group, are making their maiden sorties into hedge fund businesses with plans to launch a $1 billion multi-strategy fund.

If there were a hedge fund feature that truly exemplifies its unique nature, it would be the standard 2 and 20-fee structure charged by hedge funds. This means investors are charged 2 percent of capital invested in addition to 20 percent of profits above a specified benchmark.

Hedge funds seem to have evaded the basic economic principle of competition reducing prices. While 2 and 20 may be the standard, some funds charge much higher. Renaissance charges an eye popping 5 and 44. Hedge fund fee structures have drawn criticism from many prominent investors including the ultimate investor, Warren Buffett, who has called the compensation structure a "grotesque arrangement."

Conversely, hedge fund managers place emphasis on alpha as the raison d'etre for fees. With this fee structure, it's no surprise that five of the wealthiest U.S. hedge funds took home $1 billion or more each as the 100 best-paid managers earned an average $241 million, according to a study compiled by the magazine Trader Monthly.

John Arnold, a 33-year-old former Enron trader, delivered an incredible 317 percent before fees to investors in his hedge fund, Centaurus, by taking the other side of a bet that felled Amaranth Advisors last September, and banked an estimated $1.5 billion to $2 billion. Trader Monthly said Mr. Arnold charged his investors a 3 percent management fee and a 30 percent incentive fee.

T. Boone Pickens, SAC Capital Advisors' Steve Cohen, James Simons of Renaissance Technologies Corp and ESL's Edward Lampert, each made at least $1 billion. The best-paid hedge fund managers delivered returns of 30 percent and 40 percent last year, but the average hedge fund's returns were decidedly more meager at roughly 13 percent, according to the Chicago-based performance tracker Hedge Fund Research Inc.

Most hedge funds share five defining features:

ß Absolute Return - Usually, most hedge funds seek returns regardless of the performance of an index or sector benchmark.

ß Strategies - Hedge funds employ a variety of investment strategies and products, including trading in derivative instruments like options, futures, using arbitrage swaps, short selling, investing in anticipation of a specific event and investing in deeply discounted securities.

ß Leverage - Hedge funds employ leverage; in this market, exposure often exceeds the investment capital of the fund. With an 8:1 leverage, Amaranth wagered that the difference between the March and April futures prices of natural gas for 2007 and 2008 would widen. We all know that they were on the wrong side of this bet.

ß Liquidity - Hedge funds have limited liquidity in the sense that investors can only get in or out of the fund on certain dates and that there is a lockup period, which is the amount of time an investor is required to keep their capital in the fund prior to redeeming it.

ß Investment Minimum - The required minimum of hedge funds range from $1 million to $25 million and an accredited investor status is also required.

The Hedge Fund Spectrum
Event-Driven:
Merger Arbitrage
Distressed Debt

Relative Value:
Multi-Strategy
Convertible & Volatility Arbitrage
Fixed Income
Quantitative market
Neutral Equity

Long/Short:
Sector Specific
Opportunistic
Global/International
Short Biased

Global Macro:
Discretionary
Systematic

Hedge Fund Myths & Facts

Myth: Hedge funds are a new type of investment vehicle.
Fact: The first hedge fund was organized in 1949 by Alfred Winslow Jones and high net worth investors have been investing in hedge funds for over 20 years.

Myth: Lack of hedge fund transparency is bad.
Fact: Lack of opacity is bad. Due to the skill driven nature of hedge fund returns, the ability of managers to keep positions secretive is key. Revealing trade strategies defeats the purpose of a competitive market place.

Myth: Hedge funds charge too much.
Fact: Historically, hedge fund risk adjusted returns have been generally better than traditional portfolios. It takes skill to generate alpha and compensation for returns is always an incentive for better performance.

Myth: All the good hedge funds are closed.
Fact: There are always managers who spin off from established hedge funds to establish theirs and investors can also gain access to closed hedge funds via hedge fund of funds.

Myth: The industry is getting too big and performance is bound to suffer.
Fact: Hedge fund assets are just one tenth of mutual fund assets and fund managers are always inventing new strategies aimed at creating more flexibility and opportunities in the market.
Source: http://www.theticker.org/news/2007/...arity.As.Investors.Reap.Returns-2887150.shtml
 
I hate to be the curmudgeon here... after all, I hardly am a season financial expert, having come in from a different field. But the article that was replied in response doesn't directly address the original post. Admitttedly, the most salient point in the original post was somewhat buried.

The original post pointed out that the large correlations are a warning sign that too many hedge funds may be making exactly the same bets. If that truly is the case, then if there is any sort of sudden regime change which forces firms to close out their positions, then everyone will try to sell the same thing at once, the classic liquidity crunch. My intuition is that if the strategies used by the various hedge funds truly were diverse, then there would be less correlation.

The question of course, is how much correlation is too much - whether just because the correlations look like they did in 1998 means a lot of people are making the same bet. And of course, correlation does not imply a direct link - it could be a coincidence.
 
Arrogance like this is what is the problem, not hedge funds. HF investors have to remind their HF managers to remember the first rule of investing: do not lose money. Instead managers are focused on overcoming a hurdle rate or just being greedy.

Some investors are also to blame. When a hedge fund manager blows up a fund, and then 8 months later is able to raise millions upon millions of dollars, the question then becomes, why is the manager going to care about your money? This will lead to arrogance, which will lead to a stupid trade - such as being short DNDN. Or long Natural Gas when the fundamentals at the time did not merit such a trade.

May be we can find a correlation between hedge fund index and market indices both in fixed income world and common stock and CDS space CDX IG HY AND XO series to see the correaltion. If the correlation is huge then there might be a problem. It can be the case as joe pointed out that any adverse market news which might include geo political news to shatter the dreams of the current market might force this hedge fund animals to break loose the chains and create havoc.
One can only imagine what can happen when any single big hedge fund tries to bail out today.

I am not sure if I make sense to find the correlation between indexes.
just a thought.
 
Quoting from some article i read a long time back --Nalin

Let's consider a hedge fund that is invested in a handful of widely-held large cap stocks. Many components of the Standard & Poor's 500 are levered several times their annual operating earnings, so let's say a fund manager's stocks have an average of 3x leverage at the corporate level. Then let's assume that the manager applies 3x leverage at the portfolio level. This actually seems conservative given that we have read about several large funds using double-digit leverage ratios in recent years. Next, let's assume that a handful of large funds-of-funds (levered at 2x) comprise the investor base of the fund. Since funds-of-funds often charge their own layer of fees, they are encouraged to lever as well. Finally, the individual people that invest in funds-of-funds often lever up themselves. We will assume an individual levers at 2x.
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So when you do the multiplication math above, the leverage ratio of investor capital to assets from top to bottom is an astonishing 36-to-1. This means all you need is a 3% average drop in portfolio earnings and corresponding drop in portfolio value and some select end investors could be wiped out in the daisy chain of leverage as seen below.
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To be fair, most hedge funds short a significant amount of stock, and these positions would benefit from a market-wide decline in earnings. However, given the strong stock market of recent years and days (the Dow is now up 23 of the last 25 trading days), we think the temptation has clearly been to lessen money-losing shorts to chase after ever-increasing longs. When the tide goes out, we may find out that a lot of fund managers were swimming naked. In such a scenario, it wouldn't take a tremendous downdraft to wreak a lot of havoc given the record breaking amounts of leverage in the system.
The question may arise as to why we didn't see stories in the newspaper of funds or notable individuals having problems when the Dow got hit for just under 4% in a single day in February. The answer is that the short term drops of several percent can largely be papered over in the short run by extensions of further credit at brokerage houses and banks. Heck, we would argue that many brokers and banks that have lent money have no clue as to the true value of the collateral that is posted throughout the chain. Given that a wide range of synthetic instruments, derivatives, and less liquid asset classes are often "marked to model", it may take a number of months for the head-in-the-sand lenders to realize their collateral is worth a lot less than a hedge fund's model. We venture to guess that a sustained 10-15% drop in corporate profits along with a corresponding drop in most stocks could set off a leverage liquidation chain.
It's one thing to be willing to pay hefty hedge fund fees for outstanding stock/asset picking performance. It's another thing to pay hedge fund fees for mediocre performance juiced by leverage. We think a perfect storm is brewing that may put a downward pressure on the vast majority of asset classes simultaneously. Just as all asset classes have been going up together, they seem destined to go down together as hefty valuations and disappearing liquidity prove a toxic mix
 
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