More on Peloton
Since the start of 2008, events in financial markets seem to have become more alarming almost by the day. First we had the unbelievably rapid implosion of the $2 billion Peloton ABS fund, the biggest hedge fund failure we have yet seen outside the US. Then we had the even more stunning near-collapse of Bear Stearns – rescued at the 11th hour by JPMorgan. And then we had a dramatic rash of losses among funds that ply relative-value strategies in Japanese government bonds, such as the Endeavour Fund, which, after eight years among the most low-volatility players in the business, suddenly lost 27% in a matter of days.
When the US sub-prime mortgage market first ran into big problems last year, and the credit crisis began, it seemed clear that there must be repercussions for other markets – and thus for hedge funds too. It was not obvious, however, that one of the first effects last August would be the serious losses suffered by quant funds trading equity market neutral strategies.
Bizarre JGB hit
Likewise with the dramatic events this March. It seemed obvious that the near-collapse of Bear could not go by without disrupting markets somehow. But again, it seemed bizarre that it should hit the market in JGBs – where the sudden drying up of liquidity beggared belief for what is the second-biggest government bond market in the world after US treasuries. Endeavour, headed by Paul Matthews and Paolo Kind in London, is a well-established firm and will no doubt live to fight another day. But these sorts of sudden and hard-to-predict events probably leave most investors feeling bewildered, and very much in a nervous frenzy about what will come next.
There are some simple lessons, however, that perhaps we can already take from what has been happening. For instance, all of this should remind us above all about the dangers of excessive leverage – and especially in less-liquid markets.
When the news on Peloton first broke, after the initial shock there was also some feeling of sympathy around the industry. The firm, headed by ex-Goldman Sachs men Ron Beller in London and Geoff Grant in Santa Barbara, might not have been well liked – it was renowned, for instance, for driving a very hard bargain with counterparties. But the 70-strong team, based mostly in London, was well respected and its funds were said to have many savvy investors, including a number of present and former Goldman partners.
Peloton was also known to have been among the first to identify correctly the impending collapse of the sub-prime mortgage market. Originally, the firm ran only a multi-strategy fund, but after identifying the opportunity Peloton added its dedicated ABS strategy in December 2006. In 2007, this fund racked up what looked like a hugely impressive return of almost 87%. This was achieved in very much the same way as Paulson & Co achieved its huge returns last year – via short positions on the triple-B tranches of asset-backed securities.
Two-way trap
The implosion came barely a month after Peloton won two EuroHedge awards for 2007 – for best credit fund and for new fund of the year in non-equity strategies – with the firm being widely seen as a European version of Paulson. But there was one important difference. While Paulson had set up his dedicated credit funds as very much vehicles for the short-side trade, Peloton had conceived of its ABS fund as more of a relative value play – with the short triple-B positions set against long positions on the triple-A tranches. This was of course what explained why Peloton made "only" 87% on the year, while Paulson’s credit funds had racked up 500%-plus.
It is only more recently, however, that the extent of Peloton’s long positions has become clearer. Initially, it was thought the fund was just over seven times levered – which would have been high but not ridiculous for a credit fund before the recent market meltdown. But this turns out to have been the leverage of its net position – with total long positions actually amounting to something like $25 billion, much bigger than a short book of about $9 billion. Thus, the gross exposure looks to have had a leverage of more like 17 times – much less reasonable for a fund trading in credit, hardly the most liquid asset class even before the market collapse.
Look before you leap
Funds that are highly levered are always going to be at the mercy of their credit and liquidity providers. So although this is a severely dislocated market that might look to offer all kinds of opportunities, investors should be aware of which funds are in areas where liquidity is suspect and can disappear.
Macro and managed futures funds that stick to liquid, exchange-traded instruments should always be able to delever rapidly if and when required. There may be massive bargains in other asset classes, from small-cap stocks to convertibles to credit, but in this market investors need to be convinced about a manager’s ability to finance positions before wading in.