Hedge Funds Stumble Even When Walking; 'Conservative' Wagers Turn Sour,
Leading to Fears of a Shakeout; A One-Two Punch on a GM Bet
Gregory Zuckerman. Wall Street Journal. (Eastern edition). New York, N.Y.: May
18, 2005. pg. C.1
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Abstract (Document Summary)
Here is an example of a trade that has gone bad as one of these relationships went
awry: A month or so ago, a number of funds saw that the cost of General Motors Corp.'s
credit-default swaps (derivative securities that serve as insurance protecting a holder
against default by the auto maker) had become expensive amid worries about a
downgrade of GM's debt. The bonds also were out of favor. But GM shares still traded
well above $20, surprising strength given the weak debt prices. So some funds sold
GM's credit-default swaps or bought up GM bonds, effectively betting on the company's
debt. To protect themselves in case things got much worse for GM, the funds bet against
the auto maker's stock by buying puts, or option contracts that gave them the right to sell
GM's shares at a specified price, among other moves.
Earlier this month, when investor Kirk Kerkorian announced a $31-a-share offer to raise
his stake in GM to as high as 9%, the shares soared. The next day, Standard & Poor's
cut GM's debt rating to junk level -- a move that wasn't unexpected, but came sooner
than most had anticipated -- sending GM's bond prices tumbling. That dealt the hedge
funds a painful one-two punch: Their debt bets lost money, and the loss was
compounded when their hedge lost out as the stock price rose.
"While it is true that the market has moved in ways many of these players didn't
anticipate, the idea behind these trades wasn't simply a 'put it on red' strategy," says
Michael Pohly, head of Morgan Stanley's North American credit trading. "They're
searching for outperformance without making large, simple bets on the direction of the
market."
Full Text (1127 words)
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HEDGE-FUND LOSSES are piling up, sparking concerns about a shakeout in the
business and the possible impact on the overall markets.
But this time, it isn't a case of hedge funds stumbling on big, risky bets. In fact, hedge
funds have tried to turn tamer in the past decade or so, with fewer traders trying to
predict whether the market will soar or where interest rates are headed.
Instead, the hedge funds' seemingly "conservative" bets recently have shown their
darker side.
More hedge funds -- the lightly regulated private investment pools that count institutions
and wealthy individuals among their investors -- have been wagering on various complex
relationships between stock and debt investments, trying to squeeze out small gains
when one becomes too cheap or too expensive. Others have been working harder than
ever to hedge their investments. When these complex strategies worked, the result was
lower volatility for hedge-fund returns and a surge of interest from institutional investors
fed up with the ups and downs of the stock and bond markets.
What went wrong? Some hedge funds got burned because their hedging assumptions
failed to pan out, causing deep losses. Too many funds used similar strategies, such as
convertible-bond trading, and now find they can't exit losing trades without disrupting the
market.
All this has led to hedge-fund losses of about 1.5% so far this year. Some strategies are
down much more -- funds that focus on convertible bonds, for instance, have lost more
than 6%. Such jolting losses could also cut into the often-hefty fees, typically a
percentage of assets as well as of investment gains, collected by the funds from their
investors.
While some hedge funds, including so-called macro funds and those that focus on
commodities, still bet on big market moves, more have returned to the tack that gave
hedge funds their name more than five decades ago. The recent problems, however, are
a painful reminder of how difficult it is to properly hedge large, dynamic investment
portfolios.
"You get consistent 6% or so returns by not betting on the market, but rather on
relationships in the market," says James Bianco, president of Bianco Research LLC in
Chicago. But since many hedge funds and their investors use leverage, or borrowed
money, gains -- and losses -- are amplified. And the losses can be unexpected: rather
than a big market tumble, an odd shift in the correlations between certain stock and debt
prices increasingly can surprise traders.
Here is an example of a trade that has gone bad as one of these relationships went
awry: A month or so ago, a number of funds saw that the cost of General Motors Corp.'s
credit-default swaps (derivative securities that serve as insurance protecting a holder
against default by the auto maker) had become expensive amid worries about a
downgrade of GM's debt. The bonds also were out of favor. But GM shares still traded
well above $20, surprising strength given the weak debt prices. So some funds sold
GM's credit-default swaps or bought up GM bonds, effectively betting on the company's
debt. To protect themselves in case things got much worse for GM, the funds bet against
the auto maker's stock by buying puts, or option contracts that gave them the right to sell
GM's shares at a specified price, among other moves.
But earlier this month, when investor Kirk Kerkorian announced a $31-a-share offer to
raise his stake in GM to as high as 9%, the shares soared. The next day, Standard &
Poor's cut GM's debt rating to junk level -- a move that wasn't unexpected, but came
sooner than most had anticipated -- sending GM's bond prices tumbling. That dealt the
hedge funds a painful one-two punch: Their debt bets lost money, and the loss was
compounded when their hedge lost out as the stock price rose.
Recent deep losses in the world of credit trading also resulted from apparently safe twosided trades that went awry, rather than gunslinging.
Many funds have been buying up the riskiest slice of certain collateralized-debt
obligations, or CDOs. These are pools of corporate debt or derivatives from various
companies that are repackaged into slices with varying levels of risk and yields. The
riskiest slice, which figures to get hurt the most if companies begin to default on the
underlying debt, also had the best returns, rewarding the hedge funds. But the funds
didn't want to be caught short in a downturn in the economy, so they hedged themselves
by betting against slightly less-risky tranches of these CDOs, which would fall in value if
a rash of defaults arose.
Usually these two CDO slices are closely correlated. But when GM and Ford Motor Co.
were downgraded by S&P, the riskiest CDO slices took it on the chin, while the safer
CDO slices shrugged it off. As a result, hedge funds making this "correlation trade"
sustained heavy losses of as much as 12% in April alone, according to Merrill Lynch.
In convertibles, the problem has been that hedge funds misjudged how the convertible
market would react in a downturn. As some funds moved to trim their losses by selling
convertible bonds, which convert into shares of a company at a preset price, other funds
with similar strategies raced for the exits, worried that their own investors would get
skittish and redeem their investments.
"While it is true that the market has moved in ways many of these players didn't
anticipate, the idea behind these trades wasn't simply a 'put it on red' strategy," says
Michael Pohly, head of Morgan Stanley's North American credit trading. "They're
searching for outperformance without making large, simple bets on the direction of the
market."
This all may sound a bit familiar. Long-Term Capital Management, the giant hedge fund
that had to be rescued by Wall Street firms in 1998, sending shudders throughout the
market, specialized in buying certain bonds while betting against others. After Russia
defaulted on its debt in the fall of that year, all kinds of riskier debt that LTCM was
betting on fell in value, causing losses, while the price of investments like U.S. Treasurys
that LTCM was betting against as a hedge jumped, adding to the losses.
While few hedge funds use the same amount of leverage as LTCM, today there are
many more funds and traders at Wall Street banks chasing other relative-value
strategies, leading to hand-wringing in the market.
A big concern: If too many hedge-fund investors ask for their money back on the heels of
the recent disappointing performance, it could force more funds to sell investments to
raise cash. Some funds already have dumped investments, however, anticipating
redemptions from investors at the end of the second quarter, when many funds allow
investors to exit their funds.