(UNEDITED)
Last week, I attended the charity dinner Hedge Funds Care in Dallas. I was amazed at the turnout, over 400 hedge fund managers and institutional salespeople. I knew the hedge fund community had grown, but to see it all in one room was a major reality check. It is obvious that hedge funds are becoming a dominant player in the investment community and only getting bigger. Determining what the implications of this will be beneficial. The most noticeable change will be that volatility is here to stay, but perhaps a much larger issue is that equity prices could be disconnected from the underlying fundamentals for extended periods of time.
Total assets in hedge funds have grown quickly to about $600 billion. Even after this rapid growth, it still remains a small portion of the overall investment realm - Fidelity Investments alone manages a total of about $775 billion. While the assets under management of the hedge fund community are dwarfed by mutual funds, pension plans, and investment consultants, hedge funds hold their own in trading volume. While it is difficult to measure the amount of trading from one group of investors, Raymond Killian, CEO of ITG, estimated that hedge funds account for 25% to 30% of daily trading volume. This estimate was made in March 2002, and all the trading desks I talked to thought it was on the higher side of that range, if not a bit higher. Plus, several commented that has been higher during the past couple month, approaching almost half.
Just doing a back of the envelop calculation shows that hedge funds turn over their portfolio weekly. U.S. equity markets are roughly $12 trillion, and turnover is about 100%. Using 250 trading days, daily dollar volume is about $48 billion. If hedge funds are 25% of volume (low estimate), they trade about $12 billion a day. Using the total size of the hedge fund community of $600 billion (this number includes bond holdings, but does not included the use of leverage, so it might actually cancel out), the hedge fund community turns over their portfolio 50 times per year.
Even if the above calculation is off by a factor of five, this should concern any investor in today's market. Not only are hedge funds serving as the marginal buyer and seller, thus setting price, they often make decisions not entirely based on equity valuations or the underlying fundamentals of companies. Instead, decisions are based on the spread to another security, whether a convertible bond, a stock of a company within the same industry or a sector ETF.
There are a substantial number of managers that take a position in a security and then hedge it with another position. While these trades may be thoroughly researched, one side of the trade, if not both, is not grounded in fundamental bottoms up investment analysis. Even if both sides of the trade are thoroughly researched, the actual buy and sell decisions are often based on the spread between the two securities and how it compares historically. Plus, these trades are typically unwound after the spread gets to historical levels.
There are several strategies that make sense for an individual fund, but when several participates pursue the same strategy it creates a fallacy of composition. If a limited number of participants are involved in arbitraging various spreads, markets would be enhanced by the additionally liquidity. However, once these strategies account for a notable portion of trading volume, markets fail to adequately value securities properly.
Hedge funds also face the problem that money tends to focus on the hot strategy. At the end of 2001 convertible arbitrage was the hot strategy. After returning over 25% in 2000, convertible arbitrage funds returned 14.6% in 2001. The influx of capital caused spreads to narrow as everyone chased after the same trade. Convertible arbitrage returns fell 2.5% during the first seven months of 2002. Returns then averaged over 1% per month, ending 2002 with a 4% return. While a 4% return last year was much better than most investing alternatives, it is not the returns investors were expecting. If would have been interesting to see what would have happened if performance didn't pick up in the last five months of the year. I'm concerned that finicky investors will reallocate capital to different strategies after a bout of underperformance. If this happens, an otherwise liquid market can get very illiquid when several participants have to unwind trades. This could obviously cause a snowball effect if positions are liquidated causing the price to drop perceptibly forcing other holders of the same securities losses that might lead them to join in the selling as well.
Another concern with this new investor class is groupthink. Not only do hedge funds talk to each other, but successful funds usually spinout other funds, usually through a manager leaving to start a fund. After a few years of this, too many managers are using the same models and are looking at the same trades. Not only do these managers often look at similar trades, but have learned to trade the market in a similar manner. This has help usher in the wild volatility the markets have experienced lately. When the market gets at important inflection points, numerous managers are looking at the same indicators, price levels that the decision to buy or sell is independent, but matches those he has worked with and talked to. This combined with the amount of traders that are just trading the momentum of the market leads to quick violent moves at these important junctures.
I don't disagree with the concept of hedge funds; in fact traditional hedge funds can play a very important role in the capital markets. I'm concerned about what appears to be the growing hedge fund community that focuses on arbitrage opportunities instead of basing investment decisions based on the valuation and fundamentals of the company. I'm not sure what can be done to mitigate these concerns, so as investors it is vital to understand that the rules of the game have changed over that past five years. I happen to think it has been for the worse.
It seems fitting that last week a letter from a Japanese hedge fund manager sent to his clients after losing almost the entire fund in seven trading days was floating around the internet. I have copied it below. Keep in mind this fund was reported to have been up 70%+ in 2002.
Selected emails will be addressed in Bear's Chat.
Memorandum
To: Eifuku Investors
From: The Investment Manager
Date: January 15
Re: January 2003 Performance
Jan 2003 Trading Result
It is with deep regret that we inform you that Eifuku Master Fund has experienced substantial trading losses in the first seven trading days of January that have consumed nearly all of the fund's capital. These losses occurred principally in three position groups. The fund's portfolio is currently under liquidation with its main prime broker. There are still live positions being sold out/bought back and the Investment Manager is actively working with the fund's prime broker to preserve and maximize any remaining equity in the fund. There is however a strong possibility that there may not be any equity left at the end of the liquidation.
Positions
The fund came into the year 2003 aggressively positioned in three trade groups. To start, the fund held a significant position in a "stub" trade. This market-neutral trade consisted of a long position in a parent company and a short position in a 63%-owned subsidiary of the parent. The two stocks had exhibited a very high degree of correlation and low level of volatility. We considered the underlying merits of the position extremely attractive from both a valuation standpoint and a timing standpoint. In fact, the after-tax 63% position in the subsidiary was approximately equal to the market value of the entire parent company so that by owning this position, you owned the parent company's valuable core business at minimal cost.
The fund's second position was a relative value position in the Japanese bank sector, which consisted of long positions in three banks, a short position in one bank and some short index futures as a hedge. The position was established in late November/December as some of the weaker Japanese banks were heavily sold off in a market panic late in the year.
Third, the fund held a significant position in a Japanese tech stock that had also been excessively sold off in the last quarter of the year. We detected not only a large degree of panic selling here, but also aggressive and large short sales of the stock.
Timeline
Things got off to a bad start immediately in 2003. In the first two trading days of the year (i.e. Jan 6 and Jan 7) the fund lost approximately 15% of its capital. This was very concerning to us as it immediately put us in a precarious margin position and forced us to consider unwinding positions to raise margin. The other concerning issue was that much of the adverse activity in our positions took place in the last half hour of trading each day.
Wednesday's (Jan 8) trading result came as a real shock. While trying to raise cash in some of the fund's positions, the fund sustained a loss of an additional 15% of its capital. There were large adverse moves in the last hour of trading. This loss created a margin call at the fund's main prime broker that it could not meet. We held discussions with our prime broker throughout the day and they agreed to a day's grace period.
Unfortunately, Thursday (Jan 9) was as bad as Wednesday and the fund lost another 16% of it's capital. At the end of the day, we were severely under margin with our main prime broker. Once again, for the fourth day running, much of this loss occurred in the final hour of trading. After the close of Thursday, our prime broker decided to exercise their right to further trading/liquidation in the positions as per the standard prime broker agreement.
We worked with the prime broker Friday (Jan 10) in attempting to raise liquidity by selling positions. We did manage to work out of some size across the various positions, but the liquidation had the effect of further losses in the fund's positions. The fund ended the day down a further 12% and the week with a loss of approximately 58% of its capital. Additionally, the fund was now significantly under margin at its prime broker.
Over the long weekend (Monday Jan 13 having been a trading holiday in Japan), we had numerous discussions with our prime broker concerning strategy going forward. Eventually, they decided in accordance with the prime brokerage agreement that they needed to liquidate the fund's two largest positions, the stub trade and the long tech position, as soon a possible. They went into the market and arranged several large block trades with their various customers around the world over the course of Tuesday (Jan 14). These various block trades cleared most of the exposure to the two positions but came at a dear cost and left the fund with a loss for the day of approximately 40%. Equity in the fund was now hovering at the 3% level.
On Wednesday (Jan 15) we continued to sell out the relative value bank trade and clean up some smaller less liquid positions. At the end of Wednesday, we are left with very little equity in the fund, somewhere around 2% of start of year capital.
Where the fund is now
The fund still has positions that total approximately $80 million long and $117 million short. Of the long positions, approximately $15 million is held in lower liquidity stocks that may take some time to properly liquidate. We are still working hard with the prime broker to trade out of the remaining positions in as clean a fashion as possible. We will let you know as soon as possible what the likely outcome will be.
John Koonmen will try to contact each investor individually by phone in the next few days to further explain these unfortunate events and answer all direct questions. In particular, if any investors have questions concerning the logic and analysis behind the positions, John would be happy to answer these questions during those calls.
This letter has been very hard to write. I am sure that it has been equally difficult for you to read. We will be in contact soon.
Eifuku Investment Management Limited
