JGBs & Global De-Leveraging Hits Hedge Funds
"A man in incapable of comprehending any argument that interferes with his revenue."
Descartes,
philosopher 1650
The latest in a growing list of hedge funds that have hit the proverbial performance skids took place a few days ago. A London-based operation called Endeavour Capital with assets of US$2.88 billion has fallen 28% in value so far in March 2008 on levered exposure to the Japan Government Bond market in a relative value trade that backfired.
Endeavour was trying to execute a relative value trade in which it simultaneously buys and sells two sets of securities in the hopes that a previously stable statistical relatoinship would transpire. In many cases this type of trade is mean-reverting. Strange as it may sound this was the same theory behind the infamous Long Term Capital (Mis) Management firm back in the go-go 1988 era.
How could bright individuals with impressive professional track records garnered at the global fixed-income department at Salomon Smith Barney have fallen victim to such a terrible trading disaster. Surely their risk management should habve alerted them to the risks involved? This is more so confusing when they wrote in documents to investors that they would limit losses to 20%.
In another example of how past performance is no way a solid indicator of the future- Endeavour made 11% in 2007 then in early 2008 fell victim to credit-spread volatility that hit Peloton and other shops when the value of the collateral (AAA agency paper) fell sharply and prime brokers started to execute margin calls. The plus was pulled. This case comes across as being on the wrong side of a volatile market, the JGB market.
The lesson: investors should be particularly vigilant when backing funds where there is excessive leverage, and also where there is a liberal application of off-balance repos and swaps; instruments that are subject to prime brokerage liquidity issues.
It is also incumbent to be on top of weekly performance estimates and to ask very serious questions if more than 5% losses suddenly appear. The explanation might be simple as the manager does not know what he/she is doing and might dial up leverage to make up for performance deficit. Ask about independent marks applied to illiquid instruments including who does it, on what criteria and how frequently it is done? This is the time to ask questions, and for managers to provide the answers.
How big is the global relative fixed income issue if all funds were to blow up i nthe US$1.79 trillion hedge fund industry? Conservatively speaking, if you assume fixed income arbitrage and a proportion of global multi-strategy and event driven managers are 'in the game" and if you apply a modest 15 x leverage ratio to their capital, then the equity at risk for the banks comes up to be approximatley US$6.5 trillion. Mahalo.
"A man in incapable of comprehending any argument that interferes with his revenue."
Descartes,
philosopher 1650
The latest in a growing list of hedge funds that have hit the proverbial performance skids took place a few days ago. A London-based operation called Endeavour Capital with assets of US$2.88 billion has fallen 28% in value so far in March 2008 on levered exposure to the Japan Government Bond market in a relative value trade that backfired.
Endeavour was trying to execute a relative value trade in which it simultaneously buys and sells two sets of securities in the hopes that a previously stable statistical relatoinship would transpire. In many cases this type of trade is mean-reverting. Strange as it may sound this was the same theory behind the infamous Long Term Capital (Mis) Management firm back in the go-go 1988 era.
How could bright individuals with impressive professional track records garnered at the global fixed-income department at Salomon Smith Barney have fallen victim to such a terrible trading disaster. Surely their risk management should habve alerted them to the risks involved? This is more so confusing when they wrote in documents to investors that they would limit losses to 20%.
In another example of how past performance is no way a solid indicator of the future- Endeavour made 11% in 2007 then in early 2008 fell victim to credit-spread volatility that hit Peloton and other shops when the value of the collateral (AAA agency paper) fell sharply and prime brokers started to execute margin calls. The plus was pulled. This case comes across as being on the wrong side of a volatile market, the JGB market.
The lesson: investors should be particularly vigilant when backing funds where there is excessive leverage, and also where there is a liberal application of off-balance repos and swaps; instruments that are subject to prime brokerage liquidity issues.
It is also incumbent to be on top of weekly performance estimates and to ask very serious questions if more than 5% losses suddenly appear. The explanation might be simple as the manager does not know what he/she is doing and might dial up leverage to make up for performance deficit. Ask about independent marks applied to illiquid instruments including who does it, on what criteria and how frequently it is done? This is the time to ask questions, and for managers to provide the answers.
How big is the global relative fixed income issue if all funds were to blow up i nthe US$1.79 trillion hedge fund industry? Conservatively speaking, if you assume fixed income arbitrage and a proportion of global multi-strategy and event driven managers are 'in the game" and if you apply a modest 15 x leverage ratio to their capital, then the equity at risk for the banks comes up to be approximatley US$6.5 trillion. Mahalo.
posted by Franklin Scruggins | 12:38 PM
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