Even though on average hedge funds had a down year last year, they still outperformed the broader market and many other asset classes. As a result of this out-performance, the money allocated to hedge funds had become one of the larger positions within many investment portfolios, causing portfolio managers with defined asset weighting to reduced exposure to their hedge fund investments in order to get portfolio allocations back in-line. Now, as a result of broader market and other asset classes rallying over the last few months, the allocation to hedge funds is smaller than required, reducing redemption requests which began increasing last fall (see the NY Times article). With fewer redemption requests, hedge funds can quit hording cash (in anticipation of new withdraws), and instead start putting capital to work in the market. As mentioned by the authors of the NY Times article, given their high fees, new regulations, and negative press, it may take some time before new money makes it way into hedge funds at the same pace managers saw just a few years ago. Nonetheless, the reduced selling alone could be enough to start increasing returns and attracting new interest among investors. This alone could be good for all investors, regardless of their individual exposure to hedge funds and other alternative investments.
According to a recent WSJ article, in the wake of the recent Madoff and Stanford scandals, hedge fund investors have been requesting their money back at an increased pace over the last few months. Morgan Stanley analysts are forecasting that assets under management could fall by another 30 percent before the year is over. This follows an already 20 percent decrease at the end of 2008, reducing total hedge fund AUM to below $1 trillion. The withdraws are getting large enough that some funds are now left with only illiquid assets, most of which have to be sold at depressed prices. Increased selling has certainly help pressure the market recently, and will likely continue to do so if the hedge fund redemption forecasts from Morgan Stanley are correct. Having the DJIA fall to 6,000 and the S&P 500 fall to 700 would certainly seem more likely under such intense and systematic selling.
Margin debt at NYSE member companies fell 37.6% for the year through November, down to $201.48 billion (see WSJ article). This is no doubt that some of this reduction came from forced margin call selling over the last few months. While rampant speculation may not reenter the markets anytime some, the reduction of speculative investments, along with past hedge and mutual fund redemption selling, is helping to clear out the excess in the market, allowing it to find a bottom and begin building a base. January is often used as a bellwether for things to come in the markets, and the market action on the first trading day was encouraging - yet one day does not make a market. Nonetheless, January will certainly continue to generate interest as the confluence of a new year, a new president, a new congress, a new stimulus bill, and an unfolding credit crisis continue to intertwine in what will continue to generate some interesting times, not to mention opportunities in the market.
Banks are continuing to ask for more collateral to back past hedge fund lending, causing more funds to liquidate their positions (see WSJ article). When added with investor redemption, bank-induced liquidation is forcing hedge funds to step-up their deleveraging. Such selling is continuing to put pressure on the market, generating more requests for bank collateral and investor redemption, in what amounts to a catch-22 that continues to spiral the market downward. Such selling has been occurring for a while, as funds have been unwinding exposure to financial and energy stocks, both of which continue to suffer as crude oil continues to drop, and the credit crisis continues to unfold. While Hedge Fund Research recently reported that the level of hedge fund market exposure has decreased by one-third over the last year, I suspect that this still may not be enough. As mentioned by Antonio Munoz-Sune, head of the U.S. for fund of funds EIM: "The combination can take anyone down." Unfortunately, it is difficult to tell where we are in the hedge fund closing and deleveraging process, with many hedge funds still appearing to use every rally as an opportunity to sell. I suspect that until we see the VIX approach more normal sub-30 levels, stop seeing the DJIA and S&P 500 Index post intra-day percent swings in the high single digits, and see crude oil stop falling in price, it is unlikely that the market will stop feeling the effects of hedge fund selling, allowing for a long-term and lasting rally. Like most bottoms, we won't know for sure that it has occurred until we see it in the rear-view mirror, but I will be watching the VIX, the price of crude oil, and the Dow Jones and S&P 500 index percent swings for clues.
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.
Source: WSJJust 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).
As a follow-up to yesterday's post, many of the hedge funds that are being forced to liquidate positions due to redemptions and deleveraging are seeing an opportunity to take advantage of the mass selling (see Financial Times article). Hedge funds will often be holding many of the same securities, either due to using similar strategies, or simply from chasing the same hot securities. As hedge funds begin unloading these positions, selling pressure will naturally cause lower prices and additional selling in a kind of longer-term reverse short squeeze as the number of redemption notices increases. In a effort to profit from the selling, many of the same funds that are being forced to liquidate are now shorting other securities they don't currently own, but believe other funds are being forced to sell. This cannibalistic activity has been especially troublesome to some of the more popular and well known funds, such as at Ospraie, whose positions are more well-known than small, less capitalized funds. The larger funds are also natural targets given that it often takes a while for them to fully unwind their positions, providing better shorting opportunities. With the TARP bailout bill signed into law, and any benefits of the bill potentially priced into the market, we may be in store for more selling until the prey stop being preyed upon.
