A combination of falling crude oil prices and falling US and world equity markets has caused stocks over the last four days to lose almost a quarter of their value in Dubai and 17 percent in Saudi Arabian markets, just less than a week after there was an expectation that these markets were immune from the financial problems in the West (see Washington Post article). Some stress that the problems in the Gulf are more structural, with the lack of transparency and information resulting in the markets being impacted more by unsubstantiated rumors and panic selling. Nonetheless, the level of exposure is still believed to be significant. Losses from sovereign wealth fund investing in the US and elsewhere are yet to be disclosed, but are expected to be significant, causing many funds and their capital to sit on the sidelines as the credit crisis to unfold.
It appears that one potential opportunity has presented itself as a result of the ongoing credit crisis. Many larger investors investors who qualify for hedge fund investment, but who have previously been shut out due to their fund of choice being closed, may now have their opening (see Reuters article). Mass redemption are causing funds that previously closed their doors to open them back up. Of course, for many hedge funds this would still require you to have up to half a million dollars, and also nerves of steel given the daily developments in the market. While at a loss, hedge funds on average are still "only" down 9.41 percent, compared to the 30 percent drop in the DJIA over the same time frame. Yet a loss is a loss. Of course, even if you feel that the market has bottomed and decide to park your money in a hedge fund, the fund may not put your funds to work right away given that money is still being kept on the sidelines in order to deal with future redemption. Furthermore, while long-term investors should be rewarded, there is always a worry that hedge funds that continue to see larger losses and redemption may also force them to close-up shop and start new if current performance takes them too far away from any internal high water marks that are necessary to once again start taking performance fees. While the dawn does come after the darkest part of the day, it may unfortunately still be too soon to know how late it is in the evening.
The Financial Services Authority (FSA) in the UK is planning to conduct a "significant reappraisal" on how banks use securitization to free-up capital (see Financial Times article) given that mortgage bonds and other asset-backed securities are becoming more complicated than originally believed. This is important for US investors given that the FSA is the leading voice on the Basel Committee. Adjustment beyond current Basel II regulations and guidelines are already being discussed with regard to raising bank capital requirements. The problem is that as new products are developed, it is difficult to know exactly what risk are being created for all counterparties. Since the risk is often managed at the point of origination, or sold off, there has at times been less interest in formally quantifying the risk, leaving counterparties on the other side with a product that is less understood than others in terms of market and credit risk exposure.
One person close to the issue was quoted as saying that securitization of ordinary loans turned out to be "considerably more complicated than originally thought." Yes, but in many cases it was not that they were more risky than previously calculated, but that the risk was never really calculated or considered in the first place. As risk was sold off and transferred, there was often an assumption that someone else was bearing the risk. In the end, the risk was not only larger than some predicted, but it was not transferred to others as expected. Contagion in the system was not hedged away as expected.
While new regulation is a given, hopefully some type of clearing house for credit derivatives and related products will also be considered to help price these assets, which will in turn will allow the markets to observe the level of risk that is currently being reflected in market prices. Regulation that encourages such transparency would be a good and necessary first step. On the other hand, if new regulation is just another way to require extra regulatory capital without really developing a mechanism for understanding the risk of the assets in question, we will once again be back where we started - not fully understanding the risk will result in companies continuing to be under-capitalized and at risk, or forced to set aside too much capital for the current levels of risk exposure. Such an outcome will simply prevent the efficient flow of capital that is necessary to spur economic growth without really addressing the problem of knowing the true levels of risk and exposure.
September may in fact be the cruelest month of all, at least for hedge funds - now even worse than the previous "comeuppance month" just this last July (see previous post). Popular funds, such as Greenlight Capital and Maverick Capital had especially difficult months (see WSJ srticle and figure below), driving year-to-date losses beyond 15 percent and more.
Just recently many were asking the question: "Where are the big hedge fund failures?" (see previous post). At that time, many hedge funds, while down, were still doing better than the broader market (see previous post). Some of the funds that were struggling were hoping to see recovery before waiting periods on redemption notices were finally met. Unfortunately, the September sell-off has only made it more likely that investors will go forward with their plans and begin pulling money out of funds (see recent post).
As a result of potential mass withdraws, there is an expectation that as investors pull money out of funds, the larger funds are the ones that are most likely to survive. This belief is felt in part since large funds have more institutional clients, such as pension funds and endowments, which are less likely to reallocate funds to another manager, especially after putting so much money into hedge funds over the last few years. This could have a profound impact on the structure of the hedge fund industry given that three-fourths of the nearly 10,000 estimated hedge funds have less than $500 million in assets under management (according to data from Hedge Fund Research).
Yet, smaller funds have their advantages as well. While being more nimble with their portfolio as the market changes, they also have the ability to form a more personal relationships with their high net worth clients. In fact, a recent survey found that while an overwhelming 81 percent of wealthy investors were looking to change their advisor, only 29 percent of investors with smaller firms were looking to withdraw funds (see previous post). When all is said and done, clients need to put their money somewhere, and trusting it with someone they know, and someone who can hold their hand during difficult times, may help some successful small managers weather the current market sell-off.
It is quite possible that both large funds (due to experience, reputation and stability) and small funds (due to being more nimble and personable) may survive, as more mid-range funds (between $500 million and $1 billion) find it difficult to be flexible enough with their portfolios, or maintain the necessary personal relationships. Like election voters this fall, those in the middle may find themselves choosing between experience and stability versus flexibility and change. Of course, just as with elections, such choices are not always as easy or as clear-cut and obvious as they seem. The hedge fund landscape will no doubt change, but it may end up looking less different than anticipated. Furthermore, while looking structurally similar, the hedge fund industry, with its innovation, flexibility, and capital, may also end up doing more to help solve the current difficulties regardless of whether one believes they were the root cause of the problem (see Financial Times article).