Hedge funds learn to revere volatility, correlation and the “option value of cash”

Some of the world’s largest pensions, endowments and hedge funds met in Boston today to discuss the future of the “absolute return” industry. Joining them were leading academics such as Stanford’s Myron Scholes and Wharton’s Sandy Grossman, hedge fund managers such as Michael Huttman, the Chairman of Millennium Global Asset Management, one of the world’s largest currency hedge funds and the heads of European and US public pensions and university endowments.

This, just as the FT reported on the historical challenges facing these investors:

“Public pension funds in US states are facing their worst year of losses in history, exacerbating existing funding shortfalls and putting pressure on government to shore them up.”

Jokes abounded today about how the asset figures printed in the 2-month-old program now needed to be adjusted downward by 20% (or much more for funds denominated in Canadian and Australian dollars). But despite not having received “absolute” returns from their hedge fund managers this year, the pensions and endowments here were actually very sanguine about the future of alternative investments.

Although the day involved panel discussions on topics ranging from the “endowprise” (an emerging form of endowment management) to the future of the funds-of-funds industry, a number of common themes arose…

Correlations Going to One



It seems that traditionally low correlations between hedge fund strategies has taken a brief sabbatical in 2008. Many speakers pointed to the non-linear aspect of the correlations between different hedge funds strategies. One panelist expressed his surprise (and moderate frustration) that the funds-of-funds in his portfolio seemed to have synchronized in the past quarter.

Liquidity Mismatch

The topic of hedge fund liquidity was also never far from the surface of the discussions. Hedge funds have been accused by some of instigating the recent market sell-off by providing a level of liquidity to their investors that far exceeded the liquidity of their underlying portfolios. Some funds-of-funds admitted today that they had undertaken what might be described as “pre-emptive redemptions” (liquidating their underlying hedge fund positions “just in case.”) This raised the question of whether large investors should actually be conducting due diligence, not just on the hedge fund in question, but on the other investors in it in order to gauge their propensity to liquidate their position.

Mark to Market Accounting

Some panelists complained that the requirement to liquidate a hedge fund or an underlying position was often precipitated by the falling market value of the position or overall portfolio. As a result, they said, a well-intentioned accounting rule may have inadvertantly sparked a liquidity-driven death spiral. They argued that some modified version of market to market is now required.

Redemption Gates

No discussion of hedge fund liquidity was complete without addressing redemption gates (see related article in today’s Times, and another on eFinancial news). Contrary to popular perception, this crowd was clearly not scared of locking in their capital as long as they knew such lock-ups would yield an appropriate illiquidity premium.

“M&M” Turns 50



Yes, for those finance students out there, the famous “Modigliani & Miller Theorem” was evoked several times in a discussion between Myron Scholes and Sandy Grossman. The Theorem (which is exactly 50 years old this year) states that in the absence of a several complicating factors, the value of the firm is not dependent on its capital structure. This begged the question: why then were financial services firms so enamored with debt, and not equity, over the past decade? Furthermore, as one audience member mused, why had the marginal cost of debt financing not risen for firms that were gradually piling on the leverage (as the “M&M Theorem” would posit)?

The Option Value of Cash

Several panelists and speakers argued that cash has been undervalued since it represented the option to invest or not to invest. When the market was steadily rising, this option seemed kind of useless. Now, anyone lucky enough to have been in cash earlier in 2008 is creaming their fully-invested peers and has enough dry powder to pull the trigger on new investments as opportunities arise. Scholes, for one, referred to this as the “option value of flexibility” and compared it to a car that is traveling slower than the surrounding traffic, and therefore still had the “option” of hitting the gas if and when required.

The Future of Funds of Funds



A panel on “top-down” vs. “bottom-up” construction of hedge fund portfolios raised the question of whether funds-of-funds could be replicated (or at least approximated) with so-called “hedge fund betas”. The importance of strategy/geography focus, and the need to go beyond the “traditional value proposition” of funds-of-funds (i.e. education, diversification, and access to the best managers) were highlighted as critical success factors by several panelists.

Recommended Reading

That’s all from our reporter’s notebook on Day One of the off-the-record “unnamed hedge fund conference” in Boston. Before we sign off, we wanted to quickly draw your attention to an article in this week’s Economist that should be required reading for anyone who wants to cut through the mass media hype about hedge funds, hedge fund leverage, and hedge fund performance. It contains a dispassionate analysis that highlights the challenges faced by the industry without assigning blame for those problems. Many of the themes raised in this piece weaved their way through the debate here in Boston today.

The Incredible Shrinking Funds…

Excerpts…

“…What is the cause of the fire sales that seem to be at the root of the industry’s problems? The obvious answer is a withdrawal of credit…Yet the role leverage has played in bringing the industry to its knees is subtler than this…”

“…Sweeping generalisations about the degree of leverage among hedge funds are misleading…According to one prime broker’s estimate, the industry as a whole has a ratio of assets to equity of about 1.3, against 1.8 a year ago. The assets themselves often contain further embedded leverage, through, for example, derivatives. A study by McKinsey, a consultancy, suggests that this might take the industry’s leverage today to two or three times equity.”

“…Even if institutions want to buy and hold their positions, some are being forced to raise cash. One hedge-fund manager says that pension funds have onerous commitments to private equity, which they are meeting by selling out of hedge funds. And there is a widespread feeling that money originated through funds-of-hedge-funds is liable to get jumpy at any hint of trouble and skedaddle if losses are made.’