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Hamlet,
an investment sequel
Michael
Wilson asks what would it take to precipitate a hedge fund crisis
This month’s candidate for the Obscure
Information Award comes from the pen of William Shakespeare himself.
Not everybody knows that the Bard was showing off his knowledge
of the topiarist’s art when he had his tragic hero Hamlet delivering
the immortal lines: “There is a divinity that shapes our ends,
Rough-hew them how we will”.
Scholars tell us that end-shaping and rough-hewing were both standard
parts of the technical language employed by professional hedge-cutters
back in the days before Messrs McCulloch and Black and Decker gave
us other things to do on our Saturday afternoons, and some insist
that this proves Will had green fingers. Be that as it may, what
most of us can certainly recall from our schooldays is that Hamlet
was also one of the bloodiest, most violent and anarchic plays ever
presented on the Elizabethan stage, and that even today the scholars
are grimly baffled by its chilling mix of eloquence, sophistication,
inventiveness, treachery and sheer murderous brutality.
Four hundred years later, the parallels are coming back into focus,
albeit in another dimension. Nobody who looks at the state of the
investment market these days can be in very much doubt that anarchy
and mayhem are on the global agenda once again; but what really
brings on the sense of déjà vu is that hedges are
right back in the centre of things. And some experts believe that
what we’re going to see very soon is not so much a trimming
and pruning of world hedge fund assets – more of a complete
flailing chainsaw massacre in which whole sections of hedge will
be smashed and permanently uprooted. Not to say, shredded.
Rubbish, you’re entitled to say. Everyone knows that hedge
funds absolutely love a spell of stock market uncertainty, because
it gives them even more scope than usual for making profitable arbitrage
trades around the jagged and broken edges of an erratic investment
scene. (If you doubt this, just look at the fine profits that many
hedge funds made after the September 11 attacks in New York last
year.) And arbitrage is of course what hedge funds do best, although
it isn’t by any means the only thing they do. Essentially,
it consists of looking for pricing discrepancies where the same
product is listed at different prices in two different markets,
and then piling in with lots of money so that make a small profit
by buying at the lower price and selling on again at the higher
price. Or alternatively you can arbitrage by buying options at one
price while short-selling the underlying securities. What could
be safer and more respectable than that?
Nothing, we’d reply, but the problem is that hedge fund managers
are only really safe as long as they stick to their own rules and
don’t misjudge the risks. As you’d expect, they’re
supposed to balance every trade with an equal and almost-opposite
play that ensures that, if anything goes wrong with their main move,
then the counter-moves will kick in and save their funds. (That’s
why they’re called hedge funds.) But if a manager ever decides
to go out on a limb in pursuit of an unsecured position, then the
chances are that you won’t get to hear about it until something
goes wrong.
Proof? Well, when the US hedge fund manager Long-Term Capital Management
crashed in the early autumn of 1998 after getting its sums tragically
wrong on Russia, the first we really knew about it was when the
papers gleefully reported that LTCM had surreptitiously geared its
exposure by up to 30 times without counterbalancing its bets properly.
Someone calculated that this one hedge fund had amassed a potential
liability of rather more than $200 bn - which was not only equivalent
to $700 for each and every US citizen, but also the equivalent of
six months’ US trade deficit. And, as the industry noted at
the time, if that was what just one rogue hedge fund could achieve,
how much damage could a hundred wrong-guessing LTCMs have done?
(Fact: there are now about 6,000 hedge funds trading internationally,
compared with just 900 in 1995, and handling an estimated $6 trillion
of cash, or $1,000 for everyone on the planet.)
Why are you so unlikely to hear about the bad news before it breaks
over your head? We probably don’t need to labour the point
here, but the whole reason why a hedge fund manager will so often
beat the market is that he demands complete discretion over what
he does with your money from day to day. One day it may be in German
blue chips, the next day it’s in coffee futures and the next
day it’s all gone into Japanese smallcaps. This, combined with
the natural tendency towards secrecy that you find in any offshore
financial centre, is enough to ensure that the formal mechanisms
for day-to-day transparency hardly exist among the hedges. Much
to the chagrin of the US authorities, which fear that hedge funds
may be an obvious route for money-laundering, not least by international
terrorists.
But before we get completely carried away with the downside of the
risk aspects, perhaps we can reassure ourselves that there are indeed
certain safeguards to protect us against the worst eventualities.
Those hedge funds which operate within conventional main-market
national centres (London, Dublin, Luxembourg, New York) are subject
to many, if not most, of the relevant standard regulations applied
by their local investment authorities. And those funds that are
based in really exotic locations are now being pulled rather more
closely into the orthodox mainstream, not just by the heavy-breathing
US authorities but also by the sheer volume of hedge fund demand
that’s been coming in from ultra-conservative pension funds.
Bermuda has been making a serious attempt to mediate between the
hedge fund operators’ natural need for secrecy and the market’s
equally natural need for transparency. It has set up a sort of permanent
hedge fund index which discreetly asks the operators for their performance
details, on the strict understanding that their full confidentiality
will be respected, and in the process it has boosted its own credibility
a great deal. Other offshore centres in more remote locations don’t
go quite as far as Bermuda in this respect, but most of them tacitly
accept that they need to do a certain amount to keep the US authorities
sweet, and that a certain amount of discreet nudging of the hedge
funds is in order if the industry’s reputation is to remain
honourable.
The Disaster Scenario
So much for the optimistic upside. But the question we’ve been
asking ourselves here at Investment International for the last couple
of months is rather different. Just what would it take to precipitate
a major hedge fund crisis? And the conclusion we’ve been coming
to is – not much at all. Indeed, considering the near-fanatical
secrecy that constantly permeates the whole industry, together with
the lack of either full and open reporting or financial supervision,
we may have already assembled all the ingredients we need for a
full-scale disaster movie. So move over, Shakespeare, here’s
the Friday-the-Thirteenth sequel – not so much Hamlet as Omelette.
First of all, we need to start by understanding that a very large
proportion of the world’s hedge fund holdings are currently
being bought by other hedge funds, which collectively repackage
them and then unitise them into funds-of-funds that they can sell
on to the pension funds. These funds-of-funds are intended to spread
their investors’ risks rather more widely than could be achieved
by following just one hedge fund manager at a time – but alas,
they also have the unfortunate side-effect of turning the hedge
fund managers themselves into the arbiters of each other’s
performance and reliability. This is not a healthy development.
Secondly, we need to acknowledge that an awful lot of hedge fund
managers are currently worried sick about their performance bonuses.
You might not be fully aware of this, but a typical manager takes
a pretty substantial cut out of the money he makes for his investors
– as much as 25 per cent of the overall winnings in an average
year - and that the main reason you never get to hear about it is
that it’s simply deducted from the fund’s results as a
running cost. That arrangement’s fine while he’s actually
making money; but when things start looking tricky for future profits
(and believe us, there are few people with better noses for trouble
than hedge fund managers), then we can say with reasonable certainty
that a few of the more unscrupulous managers will probably be tempted
to implement what we might describe as Plan B.
Plan B, in our overheated imaginations, would be for a small group
of managers to overstep the normal rules of taste and decency and
to deliberately drive down one of their fellows’ hedge funds,
specifically by shorting it in order to profit from its temporary
discomfort. Except that this time they wouldn’t be playing
with just their investors’ money in the usual way – instead,
they’d be using their own personal investment stashes and trading
in their own right. Once the profits had been made, the victimised
fund’s price could be allowed to rise again by transferring
the all negative rumours onto the next Aunt Sally down the line.
To the world at large it would look like a victimless crime –
indeed, the only real losers would be the investors themselves,
who were heavily insulated from their funds anyway and had little
right to control what happened to them.
Plan B would of course be utterly illegal, for more reasons than
we probably need to explain. Most hedge fund managers are paid such
exorbitant fees by their employers on the clear understanding that
they don’t invest on their own accounts – or else they
are required to keep such dealings absolutely clear and open to
scrutiny. But the part about managers ganging up on each other to
drive down prices has been the stuff of industry gossip for many
months. Believe us, we’ve heard it.
How bad would things have to get in the wider world before the lure
of easy money overrode somebody’s scruples and induced him
to run things on his own account instead of the company’s?
Not much worse, probably. And how well would the financial world
take it if half a trillion dollars’ worth of hedge fund holdings
went awol without warning? Would there be a measured and centralised
response, as with LTCM in the US, or would we see panic-stricken
investors dumping their hedge holdings in sheer terror at the extent
to which these secretive funds are interlinked? The mere thought
is enough to send a shiver down the spine.
Reality Bites
It’s all good box-office horror stuff, of course, and it couldn’t
happen in reality. Well, in theory of course it couldn’t, because
in theory no hedge fund could ever hope to survive the wrath of
its investors if it all went wrong and the prosecutors moved in
with the arrest warrants. But the point we’re really trying
to make is that the sheer weight of money moving into hedge funds
recently is really getting rather alarming, considering that so
little of it is predicated on basic, real-world investment instruments
like stocks or bonds.
Instead, a particularly large proportion of the new money is sitting
in derivative instruments (however loosely you wish to apply that
term) - and this, together with the ubiquitous use of heavy gearing,
is a potentially unstable structure.
Meanwhile it’s sobering to reflect that 2002 has been one of
those years when the supposedly impossible has happened with alarming
regularity. Just think of the collapse of Arthur Andersen, the prosecution
of Merrill Lynch, the scandals at Tyco, Citibank and the cross-examinations
at Deutsche Bank over dubious stock recommendations at Deutsche
Telekom. Ponder on how giants like Enron, Marconi and the telecommunications
agency KPN Qwest bit the dust, and how even Ford Motor’s bonds
are currently rated as junk. Do you need more evidence of the scope
for further mayhem?
Finally, don’t forget that August and September are the two
most dangerous months of the year for the financial markets –
all those supervisors on holiday, all those investors leaving their
money on autopilot, all those nasty little surprises creeping into
the early statistical guesses at the June and July consumption figures.
Remember that August is the month when the oil markets wake up and
decide what to do next – and that this year it’ll also
mark the beginning of George Bush’s first presidential test
at the polls. China is waiting for its new President, Europe is
withdrawing its money from America, and Japan is sinking steadily
back into what some pundits are foolishly calling national bankruptcy.
By comparison with some of the worries today’s hedge fund investors
face, Hamlet almost had it easy.
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