Notice Period D-Day

"Sentinel has constructed a fail-safe system that virtually eliminates risk from short term investing"

Sentinel Group website, August 2007

Fear and panic still appear to make good, and at times, lurid headlines. We are now led to believe that investors and hedge fund managers are now vacillating between the mental states of psychosis and neurosis. That is what the drive-by media has been focusing on the past few days as it relates to a number of high profile losses and the likely investor reaction today, August 15th, one of the key redemption notice days for hedge fund investors. It is the time when they can officially notify a manager that they wish to withdraw their funds for the end September deadline.

First, how big is this issue. This author managed to look at a sample universe of about 100 of the biggest single manager funds - many closed and many not reporting to commercially available databases. The average fund assets were about US$2.7 billion. Interestingly, offshore fund terms were similar to their onshore fund terms. 55% of these managers are global in geographical approach (so that includes Asia) and 35% were described as US-focused. 39% of the universe is multi-strategy, with other large strategies covered including distressed securities, convertible arbitrage while only about 6% were statistical arbitrage (quant-driven).

Second, the notice periods. Among the 100 funds the distribution of notice periods ran from 1 day to 1 year with major notice period buckets as follows: 30 days 22%; 45 days 27%; 60 days 20% and 90 days 19%. So, it does appear that the largest number of hedge funds do have the 45 day notice.

Third, estimating the potential "redemption outflows". If we assume that 27% of the assets associated with these hedge funds are candidates to redeem and out of that approx. 20% of them will actively do so (the avg annual turnover in a typical FoHF portfolio) then out of the observed universe that amount coming out would be approx. US$13 billion. Wow!

But, is it realistic to assume that those funds will indeed redeem all of their funds beginning with the Aug 15th notice date? Absolutely not! Life does not work that way. D-Day is not the beginning of the end. And here's why...

First, not all of these funds have suffered losses. This is hard to imagine given the medias' penchant for schadenfreuden. One can assume that only the losers will be candidates to be "panic seller" candidates.

Second, a lot depends on when the investors started investing in their funds. If they were in during 2005 for many quant funds then even recent falls might leave them in positive performance territory. Clearly though, if you invested in 2007 at the start of the year then things could look ugly right now.

Third, a lot of institutional investors, often working with consultants, have prescribed "poor performance pain barriers" below which "sell-out" orders are enforced. Who knows what those pain barriers are? -10% decline, -20% or -30%? Who knows? The 15th has come up so quickly that data on peer groups is probably only scant at best. One would typically have to wait another week for those holes to be filled. Plus unlike Amaranth, recent cases do not appear to be cases of outright fraud in which case it is an easy decision as to what to do next.

Fourth, there is almost always a lot of institutional inertia on the part of pension fund allocators. They take years to invest and it could take many months before they get out of investments. Investment committees have to meet, boxes ticked, reassurance offered by consultants and fund of fund executives. They tend to invest over a 3-5 year horizon and so it becomes difficult to sell out, especially if you are dealing with established blue-chip names. It is rather like many passengers on the Titanic whispering to themselves the mantra "surely my investment is too big and too prestigious to fail"!

This leads naturally to headline risk. Some institutions might not want to be associated with some of the recent"bail-ins". This is a tough one to quantify but certainly explains why some investors stepped up and showed resounding PR support for Goldman's hedge fund quant fund mis-steps (to the tune of US$3 billion). This is similar to the approach that Warren Buffet undertook with Salomon Brothers in the late 1990s - only then, top managers responsible for investment failings were fired...

Fifth, some of these investors may have side letters or special terms to get in and out of their investments and who knows the extent to which the biggest investors have negotiated this type of out-clause. In short, no-one knows what the damage is likely to be and how it will impact the markets.

So I will step out on a limb and say that the ultimate redemption totals that one might expect from the 100 or so biggest funds may amount to US$3-4 billion. And if we assume that Asia-Pacific geographical exposure is around 15% for some of these global funds then about US$800 million might risk coming out of Asian funds at the end of the 3Q07.

But then again that is just my best guess and like any discerning equity market neutral manager, 50% of that might be right and 50% wrong. Remember too that over the fateful 1998 time period when the summer drawdown of hedge funds stood around -14% the calendar year performance of the funds was down -0.35%.

Interestingly, the recent travails of single managers might become yet another opportunity for the growing legion of fund of hedge funds that can now pretty easily explain the benefits of their business model that is properly diversified and that offers (in most cases) a smoother return profile.
Mahalo.