Hedge funds: in for a trim

Tuesday, September 30

The hedge fund sector has to date weathered market volatility better than the banking sector, since no large bellwether hedge fund has yet gone bankrupt. Nonetheless, hedge funds are expecting a wave of redemptions, as investors move to safer investments and reconsider their commitments to the sector.

Resilience

Whereas banking sector difficulties have provoked a host of policy responses, including Treasury Secretary Henry Paulson's now-moribund 700 billion bailout package -- no hedge fund problem has yet necessitated a similar systemic response. The apparent resilience of the sector is particularly striking given that recent estimates suggest that the 2 trillion dollar hedge fund industry accounts for approximately 30% of US equity and bond trades (although volatile market conditions have led many managers to shift greater percentages of their holdings into cash-equivalents).

Hedge funds are subject to minimal regulation. Yet since hedge fund managers are allowed to invest their own money alongside that of their clients -- in contrast to the situation in the banking sector -- they theoretically have considerable incentives to focus on risk management issues. Moreover, hedge funds by design limit inflows and outflows of investments:

Storm warning

Yet the juxtaposition of the quarterly deadline today for redeeming hedge funds investments and yesterday's House vote to reject Paulson's bailout plan may lead to increased withdrawals by hedge fund investors wary of locking up their investments in what promises to be an extremely challenging quarter:

• Liquidation incentives. Some investors may liquidate their hedge fund investments not because of underperformance per se, but to increase their liquidity in the face of continued tight credit conditions, since the structure of hedge fund investments only allows redemptions at certain fixed times. Therefore, the risk averse position is to move funds into cash if it looks likely that it will be necessary to have access to funding during the current quarter. In the current tight credit market conditions -- where many investors may need to access liquidity -- there may be a rush to liquidate investments during quarterly 'redemption windows'.
• Leverage problems. In current market conditions, hedge funds' use of leverage is also highly problematic. Leverage magnifies losses, as well as gains. If redemptions or market losses force some funds rapidly to unwind their positions, this could worsen the current asset-price and de-leveraging spirals.

Hedge fund managers also face substantial near- and medium-term operating challenges. Hedge fund managers rely on complex strategies that require access to a range of instruments, including futures, options and derivative instruments, and tactics, including short selling. UK and US regulators have imposed temporary short-selling bans on certain financial shares, among other restrictions, despite limited evidence that unbridled short selling has caused share sell-offs, particularly in the financial sector. Moreover, various common trading and other hedging strategies require an investor to short one asset while going long on another.

Beyond the standard threat of hedge fund regulation, in the form of registration, monitoring, and disclosure requirements, and accelerating investigations into alleged manipulation, regulators and political figures are seeking scapegoats. Measures may not necessarily be targeted at hedge funds per se, but instead these institutions may no longer be excluded from regulation designed to mitigate systemic risks. This represents a serious long-term threat to standard hedge fund operating procedures.