"May you live in interesting times." The potent mix of blessing and curse embodied in the ancient Chinese saying – with its dual tone of opportunity and threat – will be resonating with hedge fund managers trying to navigate their way through this market crisis.
With banks scared to lend even to each other – and deeply nervous of the exposures and losses that their counterparties (and they themselves) might have – the resulting credit paralysis has been a dangerous and scary phenomenon.
Until the banks collectively reassure themselves that they are not all deep in the mire – which might happen soon or might take a long time – it will be extremely challenging to run any kind of investment business that requires any element of leverage and that assumes any normal level of liquidity in the underlying markets, particularly in anything to do with structured credit.
Sideshow
This is first and foremost a crisis of capital and confidence within the banking system, in which hedge funds are a relative sideshow. But hedge funds have not collectively done what they are supposed to do in terms of preserving capital in such an environment and, in the case of those that purport to do so, offering market neutrality.
Many funds have been hurt, some badly. The quant meltdown in early August might have hit the credibility of quant-based equity market-neutral investing for a while to come. Credit is under a cloud, although it is probably in credit markets that the best opportunities now lie.
The whole hedge fund industry has been hurt to some extent. For the industry as a whole to be down when markets are up – as happened in August – is not what hedge fund management is supposed to be about, after all.
Meanwhile, the bizarre resignation of Florian Homm and the attendant collapse in the share price of AIM-listed Absolute Capital Management – which always seemed an unlikely candidate among hedge fund firms to be publicly listed on a stock exchange – is the last thing that the industry needs right now, particularly at a time when leading industry figures are at last seizing the mantle in terms of engaging more proactively with the outside world.
Coming after a series of recent problems involving other listed investment vehicles in the structured credit area – such as Cheyne’s Queen’s Walk Investments and Cambridge Place’s Caliber – the Absolute Capital fiasco is an embarrassment for London’s AIM.
And the whole sorry episode plays right into the hands of the US stock exchanges – which, smarting from the loss of so much IPO activity to London’s apparently more competitive markets, have been alleging lax standards on the part of AIM for some time already.
So the London Stock Exchange will have been pleased to see the strong results announced in late September by BH Macro – the LSE-listed "permanent capital" vehicle for Alan Howard’s star-performing $14 billion Brevan Howard fund, chaired by former Bank of England executive director Ian Plenderleith.
August was not a great month for hedge funds, with the EuroHedge Composite Index of some 1,500 European hedge funds down by some 1.6% – its second-worst month on record, although considerably less bad than the 2.9% loss recorded in August 1998 in the throes of the LTCM crisis.
Extreme dispersion
Overall, performance was not all that bad. But the dispersion of returns was extreme. Many of the bigger brand-name firms performed far worse than the industry medians. And 75% of all hedge funds in Europe produced negative returns on the month.
On the positive side, though, events like these do make it easier for investors to differentiate between individual managers and strategies than in more benign market conditions. And periodic shake-outs are never a bad thing in this industry, particularly after a period in which shutdowns had been running at an abnormally low level.
As in any financial market crisis, a clearing price will be found for all the structured and leveraged finance that is clogging up the system. And the long-awaited repricing of risk will eventually work its way through the system, however painful or protracted that process may be.
There are already big opportunities out there, across most asset classes. And there will be many more. Those investors with the capital, the nerve and the ability to take a long-term view are already licking their lips.
Queuing up
Many hedge funds will thrive in the changed opportunity set – just as there are several that profited handsomely from anticipating the current crisis – and managers are already queuing up to exploit the new opportunities that this severe shake-down will end up presenting, either by reopening long-closed funds or by launching new vehicles.
But some, possibly quite a few, will fall by the wayside and there is likely to be an element of flight to quality among investors that might make life even tougher for the smaller hedge fund firms for a while.
Overall, the bursting of the credit bubble should ultimately provide a rich environment for a wide range of strategies – in distressed, macro and credit particularly, but also in such areas as event-driven and long/short, despite the likely slowdown in corporate activity, the retreat of private equity and the evaporation of bid premia from equity markets.
So the panic of 2007 might turn out to have been a great buying opportunity. Or it might turn out to have been the start of something far worse. Nobody knows just yet. Either way, though, times will stay interesting for a while to come.