Strength in the U.S. stock market has spelled relief for the hedge fund industry and losses for options-based hedging strategies.
While many hedge fund managers suffered losses during 1998's late summer global stock market downturn, options hedging strategies finally were able to show their worth following years of losses. But the stock market's subsequent resurgence led to a recovery of sorts for many hedge funds, and a relapse for options-based equity strategies.
As a result, overall hedge fund redemptions at year end were less than feared -- about 10% by estimates -- and institutions appear to have held on to their hedge fund allocations as well.
"Even if (institutions) had somebody who blew up, they also had three or four others that didn't disappoint them," said E. Lee Hennessee, managing principal with the Hennessee Group LLC, New York.
Redemptions overall came in at 10% to 15% of assets, said Marc Spungin, president and chief investment officer for manager-of-managers Prairie Investment Management LLC, Chicago. "I think it's a positive," he said.
Institutions contacted were holding steady, and maybe adding some managers. Officials at Vassar College, Poughkeepsie, N.Y., are going a step further, and might even increase their hedge fund exposure.
Board members will ponder increasing the hedge fund allocation at the board's next meeting this month, said Jay Yoder, director of investments for the $540 million endowment fund.
The staff recommendation is to increase the fund's allocation to 14% from its current 10%, he said.
"The case for hedge funds hasn't changed, despite a poor quarter or two," Mr. Yoder said in reference to hedge fund performance in 1998.
Endowment staffers also will recommend hiring an additional manager in a hedge fund style that would be new to Vassar's endowment. He declined to say which style is under consideration.
The endowment fund for Denison University, Granville, Ohio, just invested $15 million with a technology-focused hedge fund manager.
Denison hired the Spinnaker Technology Offshore Fund Ltd., said Seth Patton, vice president for finance and management for the $320 million endowment.
Spinnaker's portfolio managers are technology-focused stock pickers that can go long and short stocks, Mr. Patton said.
The hiring was made primarily with assets from rebalancing from existing hedge fund managers: Tiger Management Corp., New York; Duquesne Capital Management, Pittsburgh; Deerfield Partners LP, New York; Moore Capital Management, New York; and Lone Pine Capital LLC, Greenwich, Conn., he said.
Hedge funds compose about 24% of the endowment fund's assets, he said.
The University of Richmond, Richmond, Va., shifted about 3% of its $750 million in assets to multievent arbitrage hedge fund managers, taking the money from macro-style managers, said Louis Moelchert, vice president for investments.
The move slightly increased the fund's exposure to hedge funds, he said. "I just think these are good strategies over a long period of time."
He declined to name the managers hired or which managers gave up assets, althought none were terminated, he said.
Richmond has 15% of its assets in hedge funds as part of a 40% allocation to alternatives, he said.
Despite the rebound for some hedge fund managers, the outlook for the now infamous Long-Term Capital Management LP, Greenwich, Conn., is less certain. Myron Scholes, one of Long-Term's most visible partners, announced his planned retirement from the firm last week, as did another original partner, William Krasker.
And the rebound has meant losses for options hedging programs already in place, because rising stock prices have deflated the value of options strategies.
The Colorado Public Employees' Retirement Association, Denver, continues to take losses on its call option writing program, said Robert J. Scott, executive director. (Mr. Scott's comments are taken from an interview and a speech at a risk conference sponsored by the Chicago Board of Trade, the Chicago Board Options Exchange, and the London International Financial Futures and Options Exchange.)
"We're happy to lose money on options," Mr. Scott said, adding the program wasn't designed for market timing; it loses money in rising equity markets.
The options overlay was put in place as a means to allow for a higher equity allocation.
"Because we've taken a more aggressive approach (in equities), we felt like there's got to be a way to dampen volatility," he said.
As a result, Colorado's current equity allocation -- including private equities -- is about 78% of assets at market value, Mr. Scott said.
Colorado writes call options against $2 billion of indexed equities, which are part of its $16 billion public U.S. equities portfolio. (The retirement association oversees $26 billion in total.) Data provided by the Colorado fund show its returns to be higher than the average public pension fund but with less risk.
In the five years ended June 30, 1998, Colorado's fund returned 15.7% annualized with a standard deviation of 6.7%, compared with the average public fund's return of 14.4% and volatility of 6.8% in the same period.
Mr. Scott said returns would have been higher had Colorado used its higher equity allocations and no options overlay, but volatility also would have been higher. The Colorado fund would have returned 16.6%, with a 7.2% volatility after taking out the effects of the options overlay program.
"For us, it's been sort of a no-brainer," he said.
But, he said, the program has required a great deal of education so any losses from the program are not a surprise to board members.
Colorado manages its program in-house, using an options computer model designed by Rampart Investment Management Co. Inc., Boston.
For similar reasons, Children's Hospitals and Healthcare, Minneapolis, uses options to hedge equity investments made with the hospital's corporate cash.
Susan Slocum, treasury director, said hospital officials want to participate in the stock market, but don't want to lose money beyond a certain amount.
So Children's hired options manager the Clifton Group, Minneapolis, to construct hedges for the portfolio. A problem with the system's hedge became apparent in 1998. The hospital's equity investments had a value orientation, and because value stocks underperformed growth stocks as the market recovered, its hedge lost more value than Children's earned back in its equities.
As a result, the hospital realigned its managers to better fit the index options it is using to hedge, Ms. Slocum said.
Despite Colorado's and Children's satisfaction with options, other institutions don't appear to be active after the market's recovery. Many have bailed out of options overlays as the market goes continually higher, beginning as far back as 1996.
And buying put options hasn't caught on widely either, although year 2000 issues are leading to some interest. "It's not very common" for long-term investors to hedge equity portfolios, and for good reasons, said Narayan Ramachandran, principal for Morgan Stanley Asset Management Inc., New York.
The costs are high, while long-term investors should not be concerned with short-term gyrations.
Even in a volatile year like 1998, he said, the market rebounded so quickly from its lows that hedging gains were not likely to have been realized by investors, particularly if their hedge was constructed around the calendar year.
"If you have extraordinary confidence in your" ability to call the market, then it might make sense to hedge, Mr. Ramachandran said.
Even then, he said, using futures to adjust allocations makes more sense, and are cheaper to use.