The financial crisis of 2008 impacted hedge funds like all other market participants, exposing deficiencies in their management of risk, although it has since improved, making hedge funds more transparent and institutional investors more willing than ever to incorporate them into their portfolios.
Hedge funds' managers have always made a point of trying to control risk efficiently. "Prior to 2008, hedge fund managers had a very large focus in terms of controlling their tail risk," said Corey Case, Chief Operating Officer and Co- Head of J.P Morgan Alternative Asset Management. "They've always done a good job at controlling that space historically."
But many investors complained that hedge funds also lacked transparency and as a result some have traditionally refused to have a hedge fund exposure. But this is changing.
Public pension funds have been increasingly adding hedge funds to their portfolios during the past five years and despite the global recession, they remain committed to the diversification benefits these vehicles can offer within their portfolios, according to a September report on hedge funds published by Preqin, a research firm focusing on alternative assets. The mean allocation to hedge funds of public pension funds has grown year on year since 2007, when it stood at 3.6% of total assets to 6.6% invested in the asset class today, according to the report.
As a result, hedge funds have reduced some major risks. Preqin found in a February 2011 hedge fund managers survey that 46% of respondents said that having more institutional investors in their funds has resulted in their firm putting more risk management procedures in place. In turn, this increased transparency and focus on risk might attract more institutional investor money going forward.
As a result, hedge funds have reduced some major risks. Preqin found in a February 2011 hedge fund managers survey that 46% of respondents said that having more institutional investors in their funds has resulted in their firm putting more risk management procedures in place.
Part of the focus of hedge funds has been on reducing leverage. The average standard leverage for all hedge fund strategies fell from 1.27 to 1.10 times investment capital, and average margin to equity also fell from 17.13% to 16.98% year over year as of May 2011, according to a report from Hedge Fund Research. HFR also found that roughly one third of all funds used no leverage, an increase of 4% over 2010. Larger funds tend to employ more leverage considering 23% of funds with assets under management over $1 billion used leverage between two and five times their investment capital, according to the HFR report. "In 2011, managers brought down leverage and net market exposure," Case said.
There have been other improvements. In the past decade, hedge funds' managers were extremely biased and would stick to their investment thesis without paying too much attention to the macroeconomic environment, even in difficult markets. It has changed in the last couple of years. "You've certainly seen managers taking into account macro views," said Case. "Now, they're taking more of the macro picture into account in their portfolio construction, although there's still a fundamental bias. But that's certainly a net positive."
Hedge fund managers are also doing a better job at managing liquidity. "Equity investors in hedge funds typically have the right to liquidity within 45 days, so managers make sure they have enough liquidity in their portfolio to meet these liquidity rights," explained Case. That mismatch between two liquidity profiles is harmless, but the mismatch between liquidity of the underlying assets and the rights of debt holders on balance sheets has been painful at times for hedge fund managers.
"On the debt side, leverage providers could change terms in half a day to three days and managers would be forced to raise cash in a difficult market," said Case. "In 2008, a lot of those deficiencies were exposed." After 2008, hedge funds have significantly improved their mismatch and have generated books that are generally more liquid. Hedge funds are trying to lock in financing terms as often as they can. "They're putting improved triggers in place to better match the liquidity of investments they've made," he said, adding that hedge fund managers have also increased the number of counterparties they use to diversify their risk profile.
While Lehman Brothers' liquidity was eroding in the fall of 2008, which ultimately led to the company filing for bankruptcy, counterparty risk was acute and impacted many market participants who didn't want to jeopardize long-term relationships and sometimes failed to reduce exposure to struggling counterparties.
"We want to make sure none of that happens with the Euro bank exposure," said Case. "In the past six to nine months, we've had a hyper focus on counterparty risk. With the European banking situation, we want to make sure we understand the complete exposure of an underlying manager and we minimize our exposure to the greatest degree."
Investors are increasingly trying to find opportunities in risky situations. "You're seeing more clients finding ways to create opportunistic buckets in portfolios to be proactive after shock events," Case said, adding that J.P. Morgan hadn't been invested in convertible arbitrage, for example, because the space was too efficient. "But post 2008, the opportunity was enormous and we jumped back in very quickly," Case said.
There have also been improvements in the risk arena from a fund-of-fund perspective. Transparency has increased in the industry allowing participants such as J.P. Morgan Asset Management to be better equipped to aggregate risks while building portfolios. Case also noted that more participants are now creating hedges in portfolios.
Hedge funds have come a long way from being labeled as highly risky, illiquid investments to now starting to be considered a normal part of any portfolio and are being evaluated within traditional allocation categories such as equity and fixed income.
Hedging is actually a cornerstone of J.P. Morgan Alternative Asset Management's risk management techniques since the firm always runs a hedge component in a portfolio "What's happening from a macro perspective matters so fund-of-fund managers need to have hedges on," said Case. "For us, the construction of that hedge has changed over the last 16 years."
Being a dedicated short seller worked up until 2008 but managers encountered challenges as regulators banned short selling. "We obviously had to have a response to that," he said, so "we augmented with short bias credit and option arbitrage. You can't have a 30% allocation to hedges but you need hedges for the worst markets."
On a standalone basis, short selling could be low single digits of a portfolio but typically not as much as 10% or 15%, according to Case. "With option arbitrage, you can put 50 basis points of exposure, which most of the time won't do much but it's not meant to," he said. That capital won't be effective until equity markets are down 10% to 20%, but once equity markets are down 20%, investors could be earning five to six times the capital that is at risk. "It's a different approach to portfolio hedging that really cuts off the tail," said Case.
The more traditional risk management strategies are also valid with hedge funds. Diversification is key to shedding risk for investors, especially when correlation is elevated, and allocating to hedge funds can increase diversification.
General derisking involving hedge funds is similar to a liability-driven investing theme. "Pension plans are trying to derisk their portfolios but can still find ways to get back to equivalent levels of return because they can't reduce their return targets," Case said.
While LDI is important, so is looking at the asset side of investing. Investors can transfer money to less volatile investments without impacting returns. "Investors take money with a traditional volatility of 10 to 15% and invest it in lower volatility equity strategies with the same return," Case said. This can be done in fixed income, commodities and equity all along the same theme. For example, in the past decade or two, many large endowments scaled back on so-called beta-one strategies, those with 100% exposure to market volatility, to shift to hedge funds. Investors interested in equity-like returns with a less bumpy ride can turn to long/short equity strategies, which typically use lower levels of leverage and tend to preserve capital better in adverse markets.
"That's a theme that's catching on across plans and we believe will increase in the next few years," said Case. Investors have, for instance, taken 5% out of equity and invested it in hedge funds because it presents the same return with less risk, or out of credit because it's the same volatility.
Hedge funds have come a long way from being labeled as highly risky, illiquid investments to now starting to be considered a normal part of any portfolio and are being evaluated within traditional allocation categories such as equity and fixed income.
"Up until the last 12 to 18 months, most investors on the institutional side would look at hedge funds as the riskiest asset class they have," said Case. The perception of hedge fund investments is changing and the 2008 crisis was a big impetus. Additionally, as many pension plans face funding problems, they find that a more ubiquitous use of hedge funds in portfolios may be one of the best ways to increase returns.
Investors are now analyzing hedge funds on a risk factor basis to fit them within their overall allocation framework. "Many investors are still treating hedge funds as an asset class, but some clients are moving away from that broad concept," Case said.
