Hedge funds: You can run but you can't hide

When the world started to melt

What will go wrong next?
Asian banks: Now comes the real crisis
Asian research: Worth the paper it's printed on?
Peregrine's still flying
Country Risk December 1997: It could be worse
Global Economic Projections: Overall Rankings

According to their fans, hedge funds fared best in the October/November turmoil in emerging markets. Hedge funds, traditionally risk-averse, can steady their returns in volatile times. They tend to run offsetting long and short positions designed to profit from pricing anomalies and low-risk arbitrage.

Funds such as unit trusts and mutual funds, which can run only long positions, naturally fared worse as the markets dived. Some other open-ended, long-only funds suffered huge redemptions as investors fled the most volatile markets, especially south-east Asia. "There's a limit to what you can do," says a beleaguered long-only fund manager. "You can raise cash to maximum limits and head for markets that have fallen already." Another reasonably successful long-only manager relies on "good stock-picking and picking non-correlated countries". But with global contagion, and an exodus of US investors from emerging-market mutual funds, earning a positive return is increasingly difficult. In the meantime, hedge funds have been able to sell futures, borrow stocks and write index swaps with investment banks.

But the triumph of the hedge funds in emerging markets may be short-lived. Because in a persistent down market, hedging becomes ever more difficult and expensive. Hedges against a bear market are best put on before a market turns bad, not during a decline. And if the prophets of doom are right, the hedges that the hedge funds had in place will expire long before we emerge from this downturn, apart from any long-term index swaps. Few conventional short-term hedges can be rolled over efficiently. Eventually, investors that entered emerging markets seeking high short-term returns must either get out or lower their sights and lengthen their time horizon.

Bid-offer spreads on stocks and bonds widened dramatically from November 3. Combined with soaring interest rates in most markets, that made the transaction costs of arbitrage between pairs of securities too expensive. The market for convertible bonds has died, because few people now expect stock prices to hit their conversion rates during the life of the bonds. Options on Brady bonds and other securities are a thing of the past.

That is the damage wrought by a few weeks of reality after years of euphoria. Liquidity in certain markets turned out to be its own enemy, since liquid securities were the first to be sold in the flight to quality, or in the pressure to meet margin calls. The best-performing emerging markets turned out to be those less dominated by foreign investors, or those so illiquid that foreign investors despaired of getting their money out. Malaysia, Thailand, Hong Kong, Japan and Brazil suffered while India, Pakistan, Turkey, and African markets generally did not. Sellers of the less liquid Russian stocks could find no buyers, so in the end they didn't sell. Because valuations of such stocks are static, that makes them look good. But for how long?

There is an irony here: the markets most liberal and open to foreign investment suffer the biggest capital outflow, while the more sticky emerging markets hang on to their foreign capital and even attract more. "Half of our portfolio is in countries where there's no impact from global capital markets and they aren't pumped up by credit," says Michael Balboa at VZB Partners in New York. He mentions Tunisia, Egypt, Pakistan, Sri Lanka, India, Ecuador, Uruguay and "frontier markets such as Latvia, Armenia and Romania".

Balboa says the warning signs of what he calls a "global liquidity crisis" have been around for some time. Jeph Gundzik, managing partner of Condor Advisers in Salt Lake City, Utah - he moved there to enjoy snowboarding at weekends - warned his select clients, including Balboa, in September 1996 that the Thai baht was heading for a fall. In May, recalls Gundzik: "I wrote to my clients that I had developed the idea of a global liquidity squeeze." This, he explained, would be caused by "the contraction of excessive leverage, through asset-value deflation and bankruptcy".

Gundzik isn't alone as a prophet of doom. But his analysis concentrated on the alarming growth of domestic credit in some countries, especially Malaysia and Thailand, where private-sector credit is up to at least 140% of GDP (see chart). Mexico's private-sector credit at the height of the peso crisis in 1994/95 was less than 40% of GDP. Gundzik maintains that a good chunk of the Malaysia and Thai credit was used to play the stock market - perhaps 10% to 15% of outstanding loans.

Such expansion of credit led to rapid contraction when the stock market turned, says Gundzik: "It happened in Japan. Other Asian countries have to go through what Japan went through." Buyers using credit to speculate in stock markets, who use the stock as collateral to leverage more, are forced sellers when the market turns. That leads to a rapid contraction and erosion of market capitalization as prices fall. Gundzik identifies four stages in this process:

1. Rapid credit expansion
2. Sudden slowdown in given economies
3. Collapse of asset values
4. Liquidity crunch

"I don't know what happens in the fifth stage," Gundzik says. But the collapse of asset values can put severe pressure on indebted companies and their creditors, usually banks. In the Mexican crisis, 46% of bank loans turned bad. For Mexico that represented around 12% of GDP, but a similar bad-loan rate in Malaysia or Thailand would total between 60% and 70% of GDP.