A gloomy but all-too-plausible scenario from Stefan-Michael Staimann and Susanne Knips of Dresdner Kleinwort regarding how the current hedge fund boom might (in their view, will) lead to a nasty bust they call “The Great Unwind.”
Their core observation is that, despite their apparent diversity, many hedge funds strategies are similar at their core: they look for anomalous prices or price relationships, most often when a spread is “wide” by historical standards and can be expected to narrow (this is a crude explanation but broadly accurate).
As the Dresdner pair points out, these are normally fairly low risk trades. However, they go through the industry’s economics, and for firms to earn the returns necessary to pay expenses and keep investors happy, they need to use a lot of leverage. And as leverage cuts both ways: it multiplies returns on the upside and the downside. So if spreads widen rather than narrow, the losses are multiplied. And if the hedge funds try to unwind their positions (if they can, in many cases there is no one willing to take the other side when markets are moving adversely), this will have the effect of widening spreads further, magnifying losses.
The problem, on a systemic level, is that these seemingly independent and uncorrelated strategies are in fact highly correlated when there is a financial crisis. Prices of risky assets collapse and risk premia gap upwards as investors flee to safe havens.
This was the lesson of the Long Term Capital Management debacle. The fund had an enormous range of positions, from swaps to emerging markets to risk arbitrage, but when Russia defaulted in 1998, all their positions moved against them, massively. The only thing that prevented a financial meltdown was that the problem was concentrated in one institution, so the Fed could get LTCM’s main counterparties in one room and knock heads together to work out an orderly liquidation.
If we have broadly the same situation, in terms of the nature of risks, but they are held in many hands, it’s doubtful that a crisis could be managed as successfully. The best hope is that rather than having a large shock that creates broad-based panic, we instead see a slow erosion, the hedge-fund version of a soft landing.
A summary of the report from the Financial Time’s blog Alphaville:
It’s the sort of analysis that, as an investment banking analyst focusing on the investment banking sector, might seriously damage your career prospects.
No matter! Stefan-Michael Staimann and Susanne Knips at Dresdner Kleinwort have published a detailed tome on the importance of hedge funds to the investment banking industry. Their conclusion? Head for the hills, because “The Great Unwind” is coming — and it’s going to hurt.
Here’s the thesis:
Transaction costs run to 4 per cent of the $1,300bn of hedge fund assets under management. Manager salaries and performance fees take another 4-5 per cent, meaning hedge funds need to generate average annual returns of close to 20 per cent to keep everyone (including their investors) happy. Yet the strategies employed to produce these returns are not necessarily sustainable.
A clear majority of hedge funds can be thought of as leveraged sellers of deep-out-of-the-money put options. They employ long-short strategies – removing market risk with what are essentially spread or arbitrage bets with a relatively low return. To boost returns they employ extensive leverage. These spread positions do produce what look like low-risk returns most of the time — but, once in a blue moon, what are effectively options written by the hedge funds will get called. Think LTCM.
While hedge fund strategies across the industry may look diversified, there is actually a high degree of correlation, since many funds are effectively running leveraged bets on stable or tightening risk premia. Any widening of risk premia will force large-scale liquidations of positions, with margin calls by the banks and redemptions by investors reinforcing the process.
Staimann and Knips declare: “We believe that the great unwind is inevitable, but impossible to time. It looks like the process of building up leveraged spread bets has already run quite far. Risk premia in many markets are very low, making it increasingly difficult to find spread bets for new money. Market volatility has been driven to record lows (remember: selling a put is like shorting volatility). The process may not have much more room to run and may start to be more sensitive to factors that could threaten its delicate balance (such as a deterioration of corporate credit risk).”
“The virtuous cycle on the slow way up (the supply and demand from building spread bets leads to tightening spreads, which in turn raises confidence to build new positions) turns into a vicious cycle on the fast way down.”
So how vicious is this great unwind going to be? Well, the Dresdner pair estimate that investment banks sucked roughly $40-50bn in revenue out of hedge funds last year, mainly through sales/trading and services other than prime brokerage. That is about 15-20% of all industry revenues in investment banking.