I recently chaired a Bloomberg discussion, targeted at small or growing hedge funds, offering advice on what investors are looking for. My panelists all had between 10 and 20 years of experience in the hedge fund or institutional asset management industry, in senior positions. The previous panel had focused on the nigh-impossibility of a small hedge fund morphing into a big hedge fund. Clearly, that wasn’t what the audience wanted to hear, and hence we were determinedly upbeat, and I think successful, in outlining what managers might put in place to enable success. Hooray for us.
Still, the really interesting discussion was in the “green room” before the presentation, where the five of us were chatting amongst ourselves. There, the discussion was darker.
We were commenting on the well-flagged trend of the hedge fund industry to be dominated by a small number of very large managers, offering institutional investors modest, but low –volatility, uncorrelated returns. So far…not controversial. But then we found ourselves all agreeing, easily and strongly, with the premise that, lurking within one of the behemoth funds of today, was another LTCM.
Conceptually, it is not possible to deploy many billions of dollars in volatile and downwardly-correlated markets, and at the same time erase that volatility and correlation. Many different investment strategies, over the years, have tried to pull this off, and all, so far, have failed. Our more seasoned readers will recall 1987’s Black Monday, when “portfolio insurance”, designed to reduce the risk of institutional investment portfolios, actually had the effect of forcing markets down rapidly and violently. The oft-cited LTCM had extremely sophisticated (for the time) risk systems.
We now hear from larger hedge funds of their superlative risk systems, the sovereignty of risk management over trading, of the hundreds of millions of dollars spent on risk management software. To be blunt: yadda yadda yadda! You cannot take risk out of an investment return. For sure, you can move it somewhere else, maybe even somewhere less visible. But you can’t remove it. That’s always been true, but the mitigator of this embedded tail risk in the hedge fund industry was its fragmentation. Today, as capital concentrates in a smaller number of very large pools, that mitigator is fading.
Deutsche Bank estimates that the global hedge fund industry manages about US$2.7tn of capital; global equity market capitalisation is approximately US$55tn. Given that a typical hedge fund may turn over its capital several times a month, the marginal importance of the hedge fund industry to global capital markets is huge. The systemic risk is meaningful.
You can’t deploy vast amounts of capital (you should be thinking not of the proportion of total market capitalisation or issuance of securities at this point; you should be thinking about the proportion of turnover/trading) without there being de facto correlation. Correlation, too, doesn’t go away; assets correlate because of human behaviour, not because of assets’ intrinsic relationships. Copper doesn’t have any intrinsic relationship with the Chinese economy. It correlates because of the behaviour of Chinese economic actors, initially, and then because investors need an investable proxy for Chinese growth. As we have always known, the majority of capital market assets are, in essence, a proxy for risk appetite; however in an age of instant information transfer that risk appetite is utterly homogenous globally. We should no longer be surprised when disparate assets correlate on the downside in a crisis, as all investors are trying to take risk off simultaneously.
Institutions have increased their allocations to hedge funds dramatically in recent years, although arguably that growth is slowing, peaking at U$1tn, according to Deutsche Bank, in 2007. Many believe that they have found an uncorrelated, low volatility, reasonably liquid strategy for their public market portfolios. One day – and perhaps one day soon – that belief will be tested.
For what it’s worth, our panel’s private conclusion was that the world’s multibillion-dollar hedge fund club is sitting on a time-bomb of tail-risk…somewhere.
