A V Rajwade: The head and tail of hedge funds

WORLD MONEY

Most funds which get into trouble have poor risk-management systems, especially for overseas operations.

Even as funds under management keep growing, some hedge funds have attracted media headlines for reasons they surely would have preferred to avoid "" losses, frauds, and so on. If LTCM "" and the systemic risk it posed a few years ago "" has not been repeated, the collapse of Bayou Management, Mother Rock and Refco evidence the risks. To be sure, with an estimated $ 1.2 trillion under management (up from less than $ 3 billion a decade ago), spread over around 8,500 funds, the number of such cases does not still evidence a "fat tail", or an unusually large number "" as it is, the mortality rate in hedge funds is around 7 to 10 per cent per annum of the population with a much higher percentage in the first year.

The biggest case that made recent headlines was that of Amaranth, a relatively large hedge fund with assets under management totalling $ 9 billion at the beginning of the year. Thanks to some huge bets on the price of natural gas, which went wrong, the fund lost almost two-thirds of its assets in a couple of weeks, a loss bigger in absolute terms than LTCM's! Clearly, the loss evidences weak risk-management systems. To be sure, in terms of historical volatility, the chance of the big price movement was extremely low, but stress tests are meant to throw out such scenarios. Another parallel with Michael Milken of Drexel Bernham Lambert, Nick Leeson of Barings, Rusnak of Allied Irish Bank, and NAB's options traders who also incurred huge losses for their employers is that the Amaranath trader was operating far away from the corporate office.

The Amaranth trader, Brian Hunter, earned somewhere between $ 75 to $ 100 million last year, as a result of some very profitable trading in natural gas, when large bets paid off. The case illustrates once again the asymmetry between the fortunes of the trader on one hand, and his employers or investors on the other. If the result is a gain, both share. On the other hand, if the result is a loss, it is only the investors who suffer. However, should investors be complaining too much: firstly, they had made a lot money earlier and secondly, the fund was often giving +/- 10 per cent monthly returns! The risks were obvious!

The investors included a few fund of funds. Such funds are a relatively recent phenomenon in the hedge fund industry and add one more layer of fees. But their intermediation between the investor and the investee hedge funds is aimed at diversifying exposure across different funds, after evaluating their performance and investment strategies. As the investor population no longer comprises only wealthy individuals but includes institutional investors, the fund of funds business has grown. Perhaps half of the total investment now comes through this vehicle "" indeed, their popularity is such that one fund of funds is likely to make a public issue shortly. Not that the managers of fund of funds necessarily act prudentially "" recently, in Hong Kong, investors in a fund of funds lost almost half the money invested!

Apart from the investors in Amaranth, other worried stakeholders would be the investment banks acting as prime brokers. Prime brokers provide all kinds of services to hedge fund clients "" like back office and settlement services, security lending, acting as counterparties, funding, and so on. This is one of the fastest growing and lucrative parts of investment banking. Fee income totalled around $ 10 billion last year, over and above even larger trading commissions. (Hedge funds are often very active traders.) An indirect benefit surely comes from the knowledge the banks' own proprietary trading desks gain from the strategies being followed by major players. But the Amaranth case obviously illustrates the risk side of the coin "" more so, as too many funds seem to be exposed to commodity markets, following similar strategies and models.

What of regulation? Recently, US courts have thrown out an SEC rule, making registration mandatory. But the Congress is considering a bill covering disclosure. Hedge funds face somewhat tighter regula-tion in London, the other major centre. Investors are from the US (60 per cent), Europe (30 per cent) and Asia (10 per cent). One recent development is that, in the equity investment area, hedge fund and private equity strategies are coming nearer each other "" but more on this in a later article.

Tailpiece: Currency markets have been showing sideways movements for an unusually long period. With no trend to help, several hedge funds specialising in currencies have lost anywhere up to one-fifth of their principal this year. But why talk of hedge funds alone? Even Warren Buffett, the legendary investor, is waiting to make money from his short dollar position. Clearly, there is a lesson in this for those who believe that they can predict the currency market!

Email: avrco@vsnl.com