Taking the rough with the smooth

The hedge fund industry is no stranger to negative press.

The widely publicised success of many managers combined with a lack of transparency and understanding has always made them an attractive target. Hedge funds just ended arguably their worst quarter since the industry began and head towards their first year of negative returns. An industry that has so far been characterised by success and rapid growth is facing a meaningful net outflow of assets. Now, more than ever, hedge fund managers have to work increasingly hard to maintain, and more importantly restore, their reputations.

Hedge funds held up well in the first half of the year with HFRX Global losing 1 per cent against world equities which lost 14.3 per cent in the same period, as measured by MSCI World. The industry then suffered from sharp trend reversals in over-crowded trades in July and August as financial stocks rallied and commodities, especially oil, tumbled. After suffering two months of relatively small losses, the hedge fund industry was hit in September by a common risk factor – the instability of the entire financial system. It turned out that the perceived risks hedge funds posed to prime brokerage business were in fact almost perfectly reversed.

The volatility of market indices increased substantially with the volatility index spiking to 80 – almost double the level seen in 1998. This volatility was largely driven by the financial sector. Companies trading on attractive fundamentals, common hedge fund long positions, sold off indiscriminately.

On top of the rapid increase in volatility, hedge funds also faced a sharp increase in trading costs. Hedge funds rely on the stability of the financial system and are significantly exposed to their banking counterparts. Managers quickly moved assets to counterparties that posed a reduced risk but this came at a high price. To top things off, default protection on financial stocks rose sharply on fear that banks would be allowed to fail.

Policy responses around the world, to the biggest financial crisis since the Great Depression, have been vast and unprecedented. Interest rates have been drastically cut as fears of inflation evaporated overnight. Central banks around the globe have poured massive amounts of capital into the system in an attempt to fuel the economy. Regulators rushed to protect the financial services industry by banning short selling, which at the time was done with all good intentions, but with hindsight had unintended repercussions by reducing liquidity in the market and adding to fear that the market was unable to function. The banking landscape has changed forever as the two remaining investment banks applied to become commercial banks, drastically reducing the way they can trade and the amount of leverage they are able to use.