Have Hedge Fund Managers/Investors Learned from the 2008 Crisis?

MF Global's Web site boasts that it's a broker-dealer dedicated to helping clients discover and capitalize on market opportunities. They deliver trading and hedging solutions across all assets in markets around the world. MF Global is a leading broker of commodities and listed derivatives and one of 22 primary dealers authorized to trade U.S. government securities. Unfortunately, the last part is no longer true as the New York Fed suspended conducting business with the firm. And the CME Group has cut off trading access to the firm.

The eighth-largest financial commission merchant with $8.6 billion in assets under management, MF Global was supposed to be like many futures brokerage firms, following staid and conservative management principles that generally didn't gamble company assets through proprietary trading. Unfortunately, while that might have been the case at one time, Jon Corzine (former Goldman Sachs superstar and ex-senator and ex-governor of New Jersey) turned it into a big hedge fund, making bets on sovereign debts. And on October 31, MF Global filed for bankruptcy protection, leaving behind more than $2 billion in debt to some of Wall Street's biggest players.

It appears that the lessons of the financial crisis of 2008 were lost on Corzine. Making matters worse, is that this episode is similar to 1994 when Corzine was co-lead of Goldman's fixed income group when it posted losses that almost took down the investment bank. Seems like Corzine never got the message about not taking risks one can't afford to lose, diversifying risks, not using in leverage and maintaining liquidity.

But Corzine isn't the only one lessons have been lost on. The same could be said about investors in hedge funds, which is basically what MF Global had become. Let's look briefly at some of the research on hedge funds dying.

Hedge Fund Studies and Data The risk of a hedge fund dying is so great that the 2005 study "Hedge Funds: Risk and Return" found that survivorship bias in the reported data on hedge fund returns creates an incredibly large upward bias of 4.4 percent per year. The same study found that there's a substantial attrition rate -- less than 25 percent of the funds in existence in 1996 were still alive in 2004. The difference in returns between the live and defunct funds exceeded 8 percent per year (13.7 percent versus 5.4 percent).

And making matters worse is that on average, hedge funds had a hard time keeping up with the risk-adjusted returns on Treasury bills, and there was no evidence of persistent performance beyond the randomly expected. Unfortunately, investors didn't learn from their experiences as money poured into hedge funds in record amounts after the 2000-02 bear market.

As bad as the returns data was, it got even worse during the recent crisis (when hedge funds are supposed to be protecting you -- some even call themselves absolute return funds). As reported in the paper "Is Greed Still Good?," the death rate for hedge funds rose to 28.5 percent. And for funds of hedge funds (which should be reducing risk via diversification), the figure was an even worse 28.6 percent.

However, this time investor behavior changed. The incoming tide of investor dollars was replaced by massive redemption requests. The demand for redemptions forced many hedge funds to dump assets. And since hedge funds tend to invest in illiquid securities, the kind that had been hit hardest by the financial crisis, the forced sales were extremely expensive to execute (as market impact costs were large). In many cases, managers who held the most illiquid assets were forced to suspend redemptions.

Under the premise of "Fool me once shame on you, fool me twice shame on me," you would think that investors would have seen enough evidence to avoid making the same mistake again. Yet, only a few years have passed, and hedge fund assets are now back to about the same levels they were before the crisis. This is even more surprising, because hedge fund performance on risk-adjusted basis wasn't very good in either 2009 or 2010.

In addition to the poor results, the high risk of dying, the lack of transparency, their returns having distribution characteristics that investors don't like (negative skewness -- the opposite distribution of a lottery ticket, and excess kurtosis -- so-called fat tails), the riskiness of the assets in which they invest, the illiquidity of the investment itself, and tax inefficiency, hedge funds also have the problem known as agency risk.

Agency Risk Agency risk is created by the standard 2/20 fee arrangement, along with the presence of a "high-water mark." While these features are sold as investor friendly and a way to incent management, they actually create perverse incentives.

Investors take all the downside risk, but don't participate fully in the upside. Agency risk can raise its ugly head when a manager approaches the end of a year and has failed to reach the benchmark level above which incentive compensation is paid. This presents a clear conflict of interest in the form of unequal incentives. If the manager takes large risks in an attempt to beat the benchmark and wins, he'll receive incentive pay. However, if the manager fails, he still receives the minimum fee and doesn't have to share in losses. This creates a problem of "moral hazard." (Note that agency risk is reduced if the manager invests significant amounts of their own assets in the fund.)

Turning to the clause that supposedly "protects" investors, the "high-water mark," it works in the following manner. After a year of negative performance, the fund can't collect its incentive pay unless it first "makes up" the negative performance. For example, if a fund loses 10 percent in the first year, its incentive pay in the second year will only be calculated on the amount earned above the high-water mark.

The problem for investors is twofold. First, the same type of agency risk just discussed becomes an issue. To reach the high-water mark and earn the incentive compensation, the fund manager may be tempted to take on greater risk than anticipated by investors.

Second, after a bad year or two, when the chances of earning any incentive pay become small, the fund manager has the right to shut down the fund, returning all assets to investors -- the high-water mark that investors counted on never comes into play. The hedge fund manager leaves and starts up a new fund with no high-water mark to overcome.

The 2/20 fee structure creates a further problem. A manager could be compensated not for generating alpha, but for taking more risk (for example by the use of leverage). Many relative value strategies commonly use leverage ratios of 5:1 or 10:1. Other strategies, such as fixed-income arbitrage and statistical arbitrage, employ even higher levels. Many strategies are able to generate large profits through the use of leverage, until the risks show up, and then years of profits are more than wiped out by one bad period. That's why these strategies are referred to as picking up nickels in front of steamrollers.

One would think that the tale of Long-Term Capital Management (at the time the largest hedge fund in the world), and its demise in 1998, would have taught investors the dangers of leverage. Yet, the lessons seem to be lost. The 2/20 fee structure allows the manager gets to keep the fees from the "good" periods, without having to return them when losses show up. Another problem is that the benchmarks were wrong. The 2/20 fee isn't a risk-adjusted one, as it should be.

And we're not yet done. Many hedge funds try to generate high returns by investing in illiquid investments. The problem is that while the time horizon of institutional investors such as the Yale Endowment may allow them to take such risks, that's typically not the case for individual investors. The problem is that history teaches us that liquidity tends to disappear just when it's most needed, during crises. Individual investors make redemption requests and assets must be sold into markets that can't absorb the sales without massive markdowns.

The problem of leverage is acute when hedge funds make investments in asset classes where liquidity can quickly disappear (such as convertible bonds and emerging market securities) and investors have the right of redemption on short notice. There are even European hedge funds that now provide weekly liquidity, yet invest in illiquid assets. The lessons seem to be lost by both the hedge fund industry itself and hedge fund investors, and the regulators as well.

The bottom line is that with assets now over $2 trillion, hedge funds have the potential to create great damage to investor portfolios and to increase volatility at the worst of times, during crises. And the lessons that investors should have learned during the last crisis seem to have been lost on most.

Photo courtesy of Tony the Misfit on Flickr.
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