This morning on the eliptical trainer at the gym I pulled out a third quarter report for a hedge fund of funds and read it. It had some numbers in it that weren’t particularly good, but were way better than I thought they’d be.
But I really wasn’t focused on the numbers this morning. I wanted to understand what had happened and what is going to happen in the hedge fund market going forward. And this letter was revealing on both fronts.
From what I could tell reading the letter, it was nearly impossible to make money managing a hedge fund in the third quarter. I am sure that there are some hedge fund managers who made money in the third quarter but most of the biggest and most experienced hedge funds lost money in the third quarter.
And I suppose the same is going to be true for October when the numbers come in. If anything, October has been worse in many ways than September was. And yet, the vast majority of hedge managers are optimistic. It probably goes without saying that you have to be optimistic about your ability to make money to be a hedge fund manager.
The big themes going forward that I took away from the letter are:
1) Fundamentals matter more than ever.
This is the only way I know to make money and that’s probably because in my market, private equity, you cannot trade and you cannot be a momentum investor. You must build value the old fashioned way, building cash flow and strong balance sheets.
2) Reduced exposure – I read this term a lot in the letter. I think it means taking risk off the table and having less leverage and more cash. I think we’ll see hedge funds be more conservative for a while until the market stabilize.
3) Migrating from equities to debt/credit markets – This weekend I spent some time with a few public market investors and they all told me that with "high quality" credits trading at discounts that provide 15-20% yields, there’s very little reason to be in the equity markets. We in the equity business often forget that credit/debt can provide equity like returns in down markets. And we are in one of those right now. This is going to suppress valuations in the equity markets and make it hard to issue new equity securities for some time to come.
4) The SEC’s attack on short selling (both naked short selling and shorting financial issues) took a toll on hedge funds. This long quote (sorry about that) explains it well.
In September, the initial announcement targeting “naked” shorting set off a massive
short squeeze as investors that were naked were forced to cover. This created losses
for all short sellers (even the legitimate ones) as the stocks rallied suddenly. The dealer
community, which had often lent more stock than they had in their possession (á la an
airline that oversells seats on a particular flight), was forced to scramble to become
compliant with the new regulations. This led them to force some accounts out of their
short positions, and to become more restrictive in their stock lending practices going
forward. At the same time, many institutions halted their stock lending programs due to
losses incurred as a result of the Lehman bankruptcy, thereby exacerbating the
shortage of borrowable stock in an already supply-constrained market.
The shorting ban on financial stocks hurt many managers’ portfolios both directly and
indirectly. Prior to the announcement, some managers had created “boxed” positions
(simultaneously long and short) in the equity of companies on the ban list to be able to
quickly hedge long positions elsewhere in the companies’ capital structures when the
time was right. The ban was put in place at precisely the time when these shorts would
have been “activated”, but instead the strategy was rendered ineffective, and the long
positions were left unhedged in a declining market. Others, who had held legitimately
established short positions in these companies (and had even taken losses on those
positions during the rally in July and August), were unable to capitalize on the trade
since the rules artificially propped up the shares and undermined their trade thesis at
exactly the moment it was expected to pay off. Another set of investors who had taken
a bearish position in the credit of these financial companies (i.e. long protection in CDS)
saw their positions marked down when the market reflected a more optimistic outlook
for the companies in the absence of so called “predatory shorting.” This move proved to
be temporary as sentiment soured again toward month end, but some positions had
already been sold.
Finally, the combination of these new rules prevented managers from capitalizing on
buying opportunities in the market. Disciplined hedge fund managers that would only
increase long exposure with a proportionate increase in short exposure were
constrained since shorting was either banned (in financials) or hard to execute (due to
lack of borrow). Even those with pre-existing long and short positions lost money as all
relative value spreads widened due to forced unwinding by investors caught in the slew
of technical forces described above.
I find that quote fascinating in its recitiation of the law of unintended consequences. Now that managers have been burned with strategies that involve short selling, it will be interesting to see if they lessen their reliance on shorting as part of their overall strategies. It seems likely to me that they will, at least for a while.
5) Shakeout – There’s a shakeout coming in the hedge fund business as the strong funds survive and the weak fail. I don’t want to reveal anything close to confidential from this fund of fund’s letter but I was shocked at how small their redemptions were in Q3 and how small the redemptions in the funds they are investors in were as well. Of course, that may change in Q4 with the December redemptions, but in any case I think investors will stick with the funds that have long track records of success and leave the funds that don’t.
Which of course begs the question about what we (the Gotham Gal and I) are doing with our hedge fund investments in light of the carnage we have witnessed and the losses we have taken. We like the funds we are in and the managers and have a lot of confidence in them. We’ve taken the hit already and my gut says it’s up or at worst flat from here so we arent’ likely to be redeeming. But as a friend said to me this weekend, "are you putting more capital in at these levels?" And that has me thinking. I don’t have an answer yet, but I do agree that you are either a buyer or a seller. If you don’t want to buy more, that tells you something.
That’s all I’ve got. I’m looking forward to the discussion in the comments. In fact, I welcome it because it will inform the answer to that last question.