By MARK HULBERT
August 26, 2007
SourceHEDGE funds may well stay vulnerable to the kind of rapidly spreading losses that have been precipitated this summer by problems in the subprime mortgage market.
The fundamental problem is that even when hedge funds say they are pursuing entirely separate investment strategies, they often actually use common approaches, according to several experts. When one of these bets goes bad for one hedge fund, losses can result for many of them, disrupting the broader financial markets.
The convergence of hedge fund strategies is quantifiable. It was detected in a study completed earlier this year by Nicole M. Boyson, an assistant professor of finance and insurance at Northeastern University; Christof W. Stahel, an assistant professor of finance at George Mason University; and René M. Stulz, a professor of finance at Ohio State University. A copy of their study, “Is There Hedge Fund Contagion?,” is at [
ssrn.com].
The professors focused on months when there was a particularly big loss in one of the many categories of hedge funds. In an interview, Professor Stulz said he and his co-authors found that during those months, all hedge funds, regardless of their category, had an unexpectedly high probability of losses, too.
A number of factors have caused this convergence, according to Lawrence G. Tint, an investment consultant and retired vice chairman of Barclays Global Investors. These include “the sheer number of hedge funds, the huge amount of assets invested in them, and the enormous amount of leverage that they employ,” Mr. Tint said. Another is a fee structure that provides hedge fund managers with “an intense incentive to capture the last little inch of competitive advantage,” he said.
Hedge funds are structured and regulated in ways that give them wide latitude to pursue profit opportunities wherever they find them. Mr. Tint says he suspects that some hedge fund investors will be surprised that their funds lost money because of problems in the subprime mortgage arena. That’s because those investors have been falsely assuming that, just because their funds focused on completely different strategies — commodities, for example — they have no exposure to the subprime mortgage market.
“There are today so many interconnections between hedge funds that, on the surface, pursue quite different approaches, that even a minor perturbation in one corner of the market causes everyone to run in the same direction,” Mr. Tint said.
Another factor that contributes to rapidly spreading losses, or contagion, among hedge funds is the proportion of their holdings invested in assets that cannot be readily sold. Hedge funds are attracted to such illiquid assets because their expected return is often higher than that of liquid investments. But that higher expected return carries a price: it makes it harder for the funds to raise money when credit becomes tight.
One expert who has worried for several years about the risks caused by hedge fund illiquidity is Andrew W. Lo, a finance professor at the Massachusetts Institute of Technology and director of its Laboratory for Financial Engineering. He is also chief scientific officer at the AlphaSimplex Group, a hedge fund management firm in Cambridge, Mass.
Hedge funds do not generally divulge their holdings, so the extent of illiquidity must be measured indirectly. Professor Lo does this by measuring the degree to which hedge fund returns move in the same direction from month to month — a statistical pattern that some call return persistence. This is a telltale sign of illiquid investments, he argues, because their valuations typically are updated infrequently — say, once a quarter or once a year. In such cases, hedge funds have to make a number of assumptions when coming up with how an illiquid investment performed in a particular month, and they may simply extrapolate it from past returns. This will have the effect of making an illiquid investment’s month-to-month returns appear to move in the same direction.
In an interview, Professor Lo said he began noticing as early as five years ago that return persistence was becoming more prevalent in hedge funds, and that it has become even more so since.
As an example of how this measurement could have been used as an early warning signal, he refers to Amaranth Advisors, the hedge fund that failed last September. The particular trade that caused huge losses for that fund, and eventually led to its closure, was a complex derivative involving natural gas futures contracts. Professor Lo said that this derivative appeared to become quite illiquid in mid-2006, as evidenced by a big spike in its return persistence. This indicated a marked increase in vulnerability for hedge funds invested in it, according to Professor Lo.
It turns out, however, that relatively few hedge funds were invested in that derivative, so the ripple effects of Amaranth’s failure were relatively mild. But that was something of a lucky break, Professor Lo said. Today, the odds are higher than ever that losses in a remote corner of the financial markets will spread quickly across the hedge fund world.
Professor Lo likened his warnings about hedge fund illiquidity to those of a weather forecaster pointing out that a forest has become extremely dry and vulnerable to fire. “Such a report can’t be used to predict when a spark will actually trigger a rapidly-spreading fire,” he said, “but it does tell you that it has become significantly more likely to happen at any time.”
Mark Hulbert is editor of The Hulbert Financial Digest, a service of MarketWatch. E-mail:
strategy@nytimes.com.