Does anyone remember when single-strategy hedge funds started branching into other strategies with a passion three years ago? The big debate back then was style drift, and whether these managers had the experience to invest in asset classes beyond their existing expertise.
After a brief period of humming and hawing, investors decided it was better for a fund to have broader investment opportunities, and the hedge fund managers’ performance in multi-strategy funds eased any concerns about their expertise.
What no one considered at that time, however, were the implications that enormous funds investing across a range of asset classes would have for the broader financial markets, and portfolio risk levels.
According to research from Lipper, multi-strategy funds account for almost one-third of hedge fund industry assets – about $600 billion. And most of that money is invested with a relatively small number of multi-strategy players.
Being multi-strategy makes sense, and is simply an evolution of the hedge fund industry. However, the structure of multi-strategy funds has already had an impact on financial markets at large. The funds tend to use leverage across the whole firm, with the assets of each strategy used to back the borrowing. It is now presumed that the downward spiral of stock markets in August was caused by the sell-off of equities by a large multi-strategy fund that was worried about its credit positions and needed to ditch liquid assets to post more collateral.
The knock-on effect on equity market neutral funds and other equity managers was substantial, and entirely surprising given that the sub-prime fall-out was expected to be contained. The question raised, therefore, is: are multi-strategy funds creating/exacerbating the growing correlation between asset classes? Namely, if a market in one illiquid security declines, there will be a sell off in equities, the most liquid security that funds hold. The answer, one would guess, is yes. Whether this means the sky is due to fall in is a different matter but it does indicate that a single-strategy manager invested in utility stocks could be at the mercy of a multistrategy manager that is caught short in RMBS. The utility guy had better make sure, therefore, that he knows a great deal more about markets than his current niche, which means, well, that he might as well become a multi-strategy fund. And investors diversifying their portfolio of managers to encompass several asset classes be they with single-strategy hedge fund managers, or asset-specific traditional managers to spread risk, might need to have a rethink.
