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A GLOBAL MARGIN CALL SENDS HEDGE FUNDS INTO RETREAT

By Antoine Bernheim, Publisher. This article appeared in the November 1998 issue of Hedge Fund News¿.

The exceptional attention brought to hedge funds by the rescue of Long Term Capital Management has considerably raised the level of anxiety of hedge fund investors, far beyond their actual loss experience in the most recent period. While hedge fund investors lost approximately 8% of their capital in the third quarter (vs. a 10% decline in the S&P500), they were still slightly positive for the first nine months of the year, when Octobers currency gyrations and further bond related losses caused hedge fund investors as a group to fall into the red. Clearly, the LTCM virtual default is unprecedented in the history of hedge funds. Given the size of its balance sheet and the type of trades it was involved in, LTCM operated less like a hedge fund and more like a banks proprietary trading department, except for the lack of independent risk management oversight. That was the model on which its original investors were sold. The direct impact of its losses on the hedge fund investor community is relatively limited because of the unusual make-up of its investor base. The indirect impact, however, has been seminal and led to a significant credit curb forcing liquidations in the worst conditions by those hedge funds which rely on financing to execute various arbitrage strategies in mortgages and convertibles.

Each crisis in the financial markets is marked by unexpectedly sharp turns which typically hurt hedge funds. It is not uncommon for a few to get kicked out of the game. In 1987, a break in liquidity in the equity markets played havoc with risk arbitrageurs who at the time made up a significant segment of the hedge fund world. For the survivors, 1988 was the best year ever. In 1990, after the collapse of Drexel Burnham, many predicted the end of the high yield market. In fact, the high yield market presented a major opportunity and that was part of the reason why hedge fund investors did exceptionally well in 1990 in spite of a bear market in equities characterized, as now, by a collapse of secondary stocks. In 1994, mortgage backed securities traders got the ax but those who survived or started up hedge funds after the carnage had exceptional returns in 1995 and 1996. And while most of the large hedge funds were hit in 1994 by overstaying their collective welcome in the bond market, they came roaring back in the following years using different skills and styles rather than piling on a single trade.

At each crisis, liquidity contraction forces the most leveraged players out, dealers withdraw from the particular segment of the market that is being trashed and unusual opportunities are created for the survivors or the new borns. Each time hedge funds come into the spotlight, either because of losses as in 1994, or large gains such as those made in the 1992 breakdown of the European exchange rate mechanism, politicians call for added regulations until people realize that banks have a more durable impact on the way markets function than hedge funds which actually depend on banks for financing.

The chain of events which led to a temporary dysfunctional state in the credit markets and a rout in equities was certainly hard to predict but no more so than any other financial crisis in recent time. However, compared to prior crises, the hedge fund world is much larger and includes greater participation by institutional investors which are subject to politically sensitive investment committees and boards of directors. Also, more investors, particularly European and Asian, have leveraged their hedge fund investments and are forced to reduce their positions as banks are now cutting off credit. Finally, the particular weakness of the dollar is weighing on foreign investors who make up close to 50% of the invested capital. As a result, relative to performance, capital withdrawals are expected to exceed the 1994 experience, when capital outflows roughly equaled the overall trading losses for the year. After a period of frantic expansion with hundreds of hedge funds being launched, a sorting out process is neither surprising nor unhealthy and should not be confused with the end of an era. The attrition factor for hedge funds had dropped to 7% in 1997 vs. an average of 11% over the past 8 years and will certainly increase in 1998. However, talent, entrepreneurship, opportunities, not to mention greed, which have been the driving forces behind the development of hedge funds will continue to prevail. Capital and credit will follow after the current turmoil abates. u