'Amazing' problems hit in one week

Global equity market volatility in mid-October might have left the worst burn marks since 2008 on many hedge funds, but the stress has created performance dispersion that will help investors better distinguish producers of true alpha.

While equity markets have since rebounded and volatility has subsided somewhat, the week of Oct. 13 saw a “unique convergence” of unrelated and unexpected market developments that led to “amazing timing problems,” said Patrick Adelsbach, a partner at hedge fund consultant Aksia LLC, New York.

Scott C. Schweighauser, partner and president of hedge funds-of-funds manager Aurora Investment Management LLC, Chicago, summed up those factors:

• concerns over economic strength, particularly in Europe;


• a sharp drop in oil prices that worried hedge fund managers about prospects for growth in the global economy;


• “regulatory and bureaucratic overreach” specifically related to the proposed $54 billion acquisition of U.K. pharmaceutical company Shire PLC, called off by U.S.-based AbbVie Inc. because of U.S. tax inversion rules changes that came into effect after the deal was announced;


• uncertainty about the impact of the spread of the Ebola virus on airline, hotel, restaurant and leisure travel stock sectors; and


• lingering repercussions from a Sept. 30 court decision that said the federal government would not have to pay dividends to shareholders of Fannie Mae and Freddie Mac, to the disappointment of hedge fund holders.

“Unexpected market developments have become a constant part of investment, but a greater number of unexpected developments happened all at once in mid-October,” Mr. Schweighauser said.

Aurora managed $9.1 billion in hedge funds of funds as of Sept. 30.

“It was absolutely not plain sailing for hedge funds under such conditions,” said Philippe Ferreira, head of research for Paris-based Lyxor Asset Management's hedge fund managed account platform. “Everyone was affected as global markets went against most hedge fund managers.”

In fact, the 3.8% loss experienced by the Lyxor Hedge Fund index in the four weeks ended Oct. 14 was the index's largest decline since drops of 5.4% in the four weeks ended Oct. 14, 2008, and 4.3% in the four weeks ended Sept. 23, 2008, the early days of the most recent global financial crisis.

By contrast, the Standard & Poor's 500 index lost 6.1% in the four weeks ended Oct. 14 this year.

Volatility spiked sharply during the tumultuous week in question, with the Chicago Board Options Exchange's market volatility index hitting an intraday high of 31.06 on Oct. 15 before closing at 26.25, its highest level since June 2012.

That many hedge fund managers owned many of the same positions — among them Freddie Mac, Fannie Mae, Shire and AbbVie — created huge “common-holder risk,” said Craig Bergstrom, partner and chief investment officer of hedge funds-of-funds manager Corbin Capital Partners LP, New York.

“A lot of managers tried to get out of these crowded trades as soon as they could, which caused more hedge funds to start derisking, followed by even more portfolio managers trying to get out,” exacerbating losses, Mr. Bergstrom said.

And while hedge fund managers in aggregate did perform better than the S&P 500 during the week of Oct. 13, “they actually did significantly worse than expected given their net exposure, producing negative alpha, because of the stocks they were holding, particularly those stocks they held in common,” Mr. Bergstrom noted.

“Hedge fund managers were gobstopped about the size of the loss in the absence of a specific trigger,” Mr. Bergstrom said. “The true reasons behind the declines were not super-observable unless you looked at portfolios stock by stock.”

Corbin Capital managed $4.8 billion in hedge funds of funds as of Sept. 30.

Hedge fund managers were “spooked” by the unusual confluence of events during the middle week of October, and reacted very differently to the situation, said Aksia's Mr. Adelsbach.

“There were those who cut risk, sold and locked in their losses, and those who held on to their positions, rode out the dip and have money now to take advantage of good investment opportunities from the market dislocation,” he added.

October has been a “hard-to-hide month” in which hedge fund managers' investment processes and conviction became very obvious, said Adam Blitz, CEO and CIO of hedge funds-of-funds manager Evanston Capital Management LLC, Evanston, Ill.

“There are some managers who buy and hold a position, sometimes for years, for very sound fundamental reasons. During bouts of volatility, you often see hedge fund managers without strong fundamental conviction about the stock sell off, while more fundamental managers tend to ride out the volatility,” Mr. Blitz said.

Conviction made a difference in mid-October, Mr. Blitz said, noting “there's a lot of performance dispersion between those managers who rode it out and those who were forced to sell, forced to reduce their exposure or just panicked.”

Evanston Capital managed $4.9 billion as of Sept. 30.

Lyxor AM's Mr. Ferreira said investor uncertainty is likely to remain high until the next Federal Open Market Committee meeting on Oct. 28-29, when the end of the U.S.' third round of quantitative easing might be announced.

But “spreads still are extremely wide, stocks are somewhat expensive and valuations are stretched,” he said.

Plus, “history shows that every inflection regarding monetary policy is followed by periods of market tension.” As a result, Mr. Ferreira, said sharp market movements and increased volatility are likely through at least the first half of 2015.

The beta market of the past five years is gone, he said, and given heightened, continued volatility, “we need the skills of hedge fund managers to find alpha. The most skilled managers will do well because they will be able to adjust their exposures fast enough to adapt to rapidly changing market conditions.”

Given that hedge fund managers will have “no place to hide” during coming volatility bouts, “individual hedge fund selection will be extremely important,” Mr. Ferreira said.