Hedge Fund Blowups

Hedge Fund Vs. Bank Blowups

Last week a member of a hedge fund professionals networking group on LinkedIn asked a question about why we have seen more investment bank blow ups than hedge funds.

In the past 2 years there have, of course, been hedge fund blow ups starting with Amaranth in September 2006. Unlike troubled investment banks not all hedge funds suffering losses and closing downs receive press coverage. We have seen a few notable names, such as hedge funds managed by Bear Stearns, Sowood, Peloton and a few others mentioned in the papers. Many more troubled hedge funds managed to avoid major headlines. It’s not necessarily clear what exactly constitutes a hedge fund blow up. For the names mentioned above the loss was sudden and quick and resulted in eventual termination of the funds. Amaranth lost close to six billion dollars in just one week. Peloton earned a spectacular return of almost 90% in 2007 just two months before the blow up. These, however, are extreme cases. Many hedge funds suffer the slow death as they enter into periods of large draw downs. In this study we tried to identify hedge funds that have terminated since January 2008.

To analyze the rate of failure among hedge funds this year, we ran the analysis on the universe of hedge funds, fund o funds and CTA that report to Barclay’s Global Data Feeder database. To identify the blown up funds we first looked at the funds that stopped reporting performance to the database. We realize that there may be various reasons why a hedge fund would stop reporting to the database, but we believe that primary reason would be a significant drop in performance. To avoid double counting we focused primarily on the “On Shore” funds reporting performance in United States Dollars. There were 3,998 funds that reported performance at the beginning of the year. Of these funds 366 have not reported their performance since May 31, 2008. Chart 1 shows the distribution of the cumulative return of these funds since January 2007 (or later if the funds launched after January 2007).

Out of the 364 funds -156 funds or (43%) have had negative cumulative performance through their last reported date. Chart 2 shows the distribution of Maximum draw down achieved during the same period.

As we mentioned above we cannot be sure whether or not the funds that stopped reporting to Barclay’s database have indeed blown up. We do, however, consider it likely that hedge funds that stopped reporting after experiencing an extreme drawdown are in a “blow up” situation. Chart 2 shows that almost a third of the funds have experienced a drawdown of 15% or higher. This brings our estimate of defaulted funds to 2.5% or (100 out of 4,000).

Given the current market environment the estimate seems low. One factor that may account for relatively low blow up rate is the hedge fund liquidity. As an asset class, hedge funds enjoy the benefit of providing relatively stable asset base that is protected by long lock ups, strict redemption schedule, and withdrawal fees. Given these restrictions hedge funds that experience large losses are able to survive longer. It’s generally expected that the industry will experience significant redemptions at the end of the year, which may bring to the run on many hedge funds and lead to higher blow up rate. In the future issues of this newsletter we will attempt to examine the factors that may be helpful in identifying potential blow ups.

Guest post by Aleksey Matiychenko of Risk-AL, LLC

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Hedge Fund Collapse

Hedge Fund Tequesta Collapses

Fortune examines “The Death of a Hedge Fund”, specifically the Tequesta Mortgage Hedge Fund.

Tequesta’s story is similar to other, larger hedge funds that have imploded recently when they were unable to satisfy brokers’ demands for more collateral. However, Tequesta is unique for its effort to avoid the credit risk that befell other funds. Despite this fact, Tequesta collapsed when its prime broker, Citigroup, decided to pull its credit.

Tequesta is remarkable because it was performing relatively well, achieving a steady influx of returns to its investors. The hedge fund was cautious in trading prime jumbo mortgage funds with low levels of default. Tequesta would have continued its success, had it not been for the unexpected stall in the market for triple-A rated bonds. This evaporation of the market led to a fall in value for jumbo mortgage funds and to make matters worse for Tequesta, its primary brokers were forced by the credit crisis to demand more collateral. The mortgage hedge fund shut down, primarily forced by Citigroup’s desperate margin call demanding collateral that Tequesta simply did not have.

Tequesta’s fall shows that even hedge funds with strong returns are not invincible to the credit market’s decline; or, as Roddy Boyd puts it, “the wolf can be right outside the front door.”

- Richard

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Hedge Fund Collapse

Survival of the Fittest Hedge Funds

In 1859, Charles Darwin introduced his theory on “On the origin of species” through this now famous preamble: As many more individuals of each species are born than can possibly survive; and as, consequently, there is a frequently recurring struggle for existence, it follows that any being, if it vary however slightly in any manner profitable to itself, under the complex and sometimes varying conditions of life, will have a better chance of surviving, and thus be naturally selected.” The (very non organic) species of the hedge fund industry have been aptly playing out this struggle for existence over the last few months as famous names such as Peloton Partners, Carlyle Fund, Carrington Capital, Amaranth Advisors and the mother load at Bear Stearns end up in the obituaries column of financial journals. The much vaunted “strategy” which typifies the various hedge fund species be it equity long-short, event driven, arbitrage or other clearly needs to evolve to be naturally selected under the current complex and varying conditions of the market. As an example, consider Andrew Lahde’s Lahde Capital Management, a California based hedge fund: by betting against sub prime, his fund returned over 1000% in 2007 to investors. Mr. Lahde is already developing other contrarian strategies to prepare for the market’s next set of probable directions.

On March 18, Martin Wolf wrote in the Financial Times that collapses are inherent in the hedge fund model because hedge fund managers have thus far been more lucky than skilled. I believe there definitely is a certain percentage of Alpha seeking managers who are indeed truly skilled but a large majority of managers have ignored the lessons of the efficient market hypothesis or unlike my MBA students have skipped class when the classic Black-Sholes option pricing model was being discussed. I have always argued that Alpha is a constantly moving target and seekers of Alpha may want to study Heisenberg’s uncertainty principle which describes how the momentum of an uncertainly moving target may be described more accurately through a probabilistic distribution rather than an assumed intermittent occurrence. This failure of managers to constantly seek a changing alpha which may occasionally have low probability occurrences will result in an extinction of their species.

The fittest species to survive in the hedge fund universe will be those who, as Darwin wrote, “vary however slightly in a manner profitable to itself” or in other words constantly seek Alpha by having an evenly spread probabilistic distribution of returns rather than maximize returns from higher probability events. Indeed this will be the species that will not only survive but also thrive. – Guest Blogger Eric Abhyankar

Eric Abhyankar is a professor of finance at the University of Northern Virginia, Prague and provides consulting to the funds industry on finding new markets for asset gathering.

- Richard

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