Relationships between banks and hedge funds are complex: banks act as prime brokers, structure complex products and invest. Are they gathering unacceptable risks? Claire Smith investigates
Inflows of money to hedge funds have never been greater. TASS Research estimates that second-quarter 2001 inflows of $8.4bn are greater than for the whole of 2000 and more than for any quarter since it began collecting data in 1994. Well-regarded industry commentators, such as Barton Biggs of Morgan Stanley and Norman Chait of AIG, warn of a hedge fund "bubble". They says this is indicated by the ability (even of managers who have previously lost millions) to raise capital with ease, hedge funds charging investors higher fees, longer lock-up periods for investors and rumours that large institutions are buying up hedge fund capacity for future sale. And with hedge funds virtually the only bright spark in an otherwise gloomy outlook, banks are falling over themselves to scale up their activities.
Shrinkage in proprietary trading activities coincides neatly with a welter of hedge fund launches. Provision of risk capital to the market is increasingly being taken up by hedge funds and most new managers boast some experience of trading in a major bank. Their former employers are instead seeding funds, providing prime brokerage, encouraging dealing relationships and creating innovative fund structures to suit end-investor preferences. Market risk has been replaced by the risk of lending based on assets held by the bank, such as in prime brokerage, credit risk and pricing and volatility risk. The direct control that banks had over their own traders is now the subject of legally enforceable contracts between banks and the hedge funds.
The profits that can be made from providing services to hedge funds and hedge fund investors may be better quality, but banks could be retaining exposure to the most unpredictable elements of downside risk (which are necessarily unhedgeable) while effectively limiting the upside they would have had by trading directly.
Forms of exposure
Hedge fund exposure now comes in one of three forms: prime brokerage, over-the-counter transactions such as swaps, and proprietary positions in hedge funds that offset liabilities on structured product offerings. Functionally, these areas are distinct and Chinese Walls around prime brokerage prevent full transparency of fund positions across the entire firm.
Yet all areas in contact with hedge funds need quality information on which to base trading decisions. For example, Bear Stearns has a global risk management team, consisting of analysts, former traders and technical people, which works closely with margin and credit groups to ensure risk is appropriately managed real-time. This permits cross-collateralisation of OTC exposures with prime brokerage positions and consultation between the credit team, and the risk management group ensures that traders have information sufficient to give the best overall credit decision without compromising fund confidentiality.
It is difficult to write about hedge funds without raising the spectre of Long Term Capital Management (LTCM) and in some ways the experience was cathartic. Reports published in the ensuing period by leading hedge fund managers, risk management heads in top tier banks and regulators share a comforting opinion about the need for greater transparency and more strict demarcation between risk monitoring and trading. Hedge funds have realised that greater openness has tangible benefits. In exchange, the banks will allow them to post lower margins and cross collateralise. Trigger events may be less harsh and banks will allocate higher aggregate credit lines and longer term capital commitments.
Monitoring hedge funds
According to a study conducted by National Economic Research Associates (NERA), the overwhelming majority of banks monitor outstanding hedge fund exposures using a system rather than spreadsheets. The benefit of this is automatic aggregation and cross-checks.
Brad Ziff, senior consultant at NERA, says: "Banks are finding their businesses are enhanced when they take a VAR or portfolio-based approach to collateral calculation and risk management, as opposed to a mark-to-market and rules-based method."
This methodology takes account of the probability of future price change and leads to a more accurate picture of the risk elements of the fund. In contrast mark to market reacts to price changes and rules do not account for the characteristics of the different instruments held.
However, in a presentation at the GAIM conference in Geneva in June 2001, David Mordecai, International Association of Financial Engineers (IAFE) IRC steering committee member and editor-in-chief of the Journal of Risk Finance warned: "Interpreting static value-at-risk, standard deviations and confidence intervals can be problematic since hedge fund returns are not normally distributed and are highly state dependent."
Typically, VAR is quoted as a maximum loss within a certain level of confidence, for instance a 97% confidence level means the figure is likely to be breached in three out of every 100 events. This statistical analysis assumes returns that are normally distributed, whereas hedge fund returns exhibit greater probabilities of so-called tail events, which are returns at the far end of the spectrum. Hence, the usual static VAR analysis is likely to underestimate the possibility and size of losses and this is exacerbated by the greater sensitivity of hedge fund returns to prevailing market conditions.
One major contributor to LTCM's leverage was banks doing repurchases with hedge funds and then returning all the bonds held as collateral to the funds, allowing them to buy more bonds and become ever more leveraged.
This practice now seems limited to situations in which full transparency to all other legs of the trade confirms that the risks are fully hedged. But Mr Ziff says: "Some grandfathered relationships from pre-LTCM days have not changed drastically. A select group of half a dozen or so good quality accounts continue to trade in less volatile markets without posting initial margin."
Tighter security
Banks have tightened up their legal documentation, particularly in the area of netting, although new clauses have yet to be tested in meltdown conditions. Amelia Gibbons, a lawyer at Dechert, a leading hedge fund law firm, says: "Close out and netting rights reduce the amount of credit exposure parties have to one another and hence the likelihood of one party not being able to meet its obligations. This may have mitigated LTCM's losses and tempered any ensuing instability in the market at the time."
Contract negotiation centres on trigger events that give banks the right to supercollateralise (take additional collateral, typically double) or terminate dealing arrangements. Some banks consider a 15% drop in the net asset value (NAV) over a rolling 30-day period sufficient basis; others agree to 20% or more. As a prime broker or holder of collateral, a bank can liquidate positions but it may suffer losses from failures to post margin and price changes in the interim. In a situation of multiple default, others may be trying to liquidate concurrently and co-ordination between affected banks is key.
Risk management
Concentration of the business among 15-20 large global investment banks should, from a risk management perspective, ease the strain on the global financial system. In contrast, LTCM had master agreements in place with more than 60 counterparties. Mr Ziff highlights the May 2000 liquidation of the $19bn Tiger funds as a good example of how a fund that was larger than LTCM was shut down in a calm and controlled way.
Ongoing collateral management is complicated by the increasing use of multiple prime brokerage arrangements and ad hoc OTC positions, such as swaps and contracts for difference.
Stuart Bohart, risk manager at Morgan Stanley's New York-based prime brokerage and stock loan business, says: "Our risk-based approach to financing portfolios, mandates a careful evaluation of the expected performance of the assets supporting the loans, including liquidation analysis. The use of multiple prime brokers to finance identical portfolios significantly clouds this analysis. Balance sheet transparency helps to illuminate this latent liquidity risk."
Morgan Stanley uses IT consultancy Algorithmics for stress testing, VAR and liquidity analysis in its equity finance business, and is releasing the AlgoLink system to its prime brokerage clients. "The AlgoLink product allows a hedge fund manager to evaluate risk across multiple custodians. By offering AlgoLink to our prime brokerage clients, we hope to create a clearer understanding of risk and a more stable funding environment for our clients, including those who use multiple prime brokers," says Mr Bohart.
"One of the unique benefits of our partnership with Algorithmics is the ability to model complex instruments, including most derivatives. This enables robust stress testing and scenario analysis across multiple asset classes, and generates transparency reports that contain meaningful risk assessment without compromising the fund's specific investments," he says.
Risk strategies
The recent explosive growth in hedge fund structured products introduces new elements of risk to the equation and banks' strategies for managing this risk have yet to be tested.
Mr Mordecai says there are difficulties in pricing derivatives on hedge funds. "Any active management creates optionality [the non-linearity in returns that is exhibited by options] in returns. By using leverage, short-selling and trading more actively, hedge funds demonstrate greater optionality.
"Studies show that all of the major hedge fund strategies are correlated with combinations of options strategies and hedge fund equity can be viewed as a stock that is highly levered with a constantly changing asset mix. This, together with the lack of secondary market trading in hedge fund equity and flexibility of the manager to substantially modify the portfolio, violates all of the assumptions of the standard Black-Scholes model for options pricing."
A hedge fund is not subject to any supply and demand balance in itself; rather the price is derived from the cost to create or liquidate its positions. A sudden drop in the NAV of a hedge fund could result in a vicious circle of increased margin calls, liquidations, redemptions and ultimately termination if the NAV is falling at a faster rate than the fund can raise cash. This situation has more in common with a run on a bank and is aggravated when a hedge fund, like a bank, is operating with leverage.
Constraints on banks
As the NAV changes, the delta (hedge ratio) of the options embedded in the bank's structured products will change and force the bank to buy or sell more hedge fund exposure to rehedge. Gapping (when the NAV of a fund changes dramatically between dealing days) does not give banks the opportunity to rehedge.
Minimising gamma risk (the unhedged exposure to changes in delta) is critically important. Banks might hedge in instruments to which the hedge funds' returns are correlated, although this assumes that correlations are stable and that the fund continues to operate the same strategy. With full disclosure, offsetting stock positions can be used as a hedge.
Prices charged for derivatives on funds of funds can be higher than the sum of individual options on the constituent strategies. By systematically overpricing options, a bank can book profits while maintaining sufficient reserve to cushion against unhedged risks. Banks often introduce extensions and unwind triggers into the option terms that reduce its value, for example a shutdown clause that would come into play if volatility breached a certain level. Specific risk can be reduced by diversification across hedge fund strategies and managers, but this tends to work only in normal market conditions, as performance figures from the time of LTCM show.
"In extreme market conditions, almost all hedge fund strategies are subject to similar constraints because they operate in the same basic markets, borrow from the same institutions and face similar asset liquidity issues," says Mr Mordecai. "Managed futures is an example of one strategy that tends to be less reliant on bank financing and generally trades highly liquid instruments. Within strategies, hedge funds vary greatly in the prudent use of leverage and in their access to alternate forms of liquidity on favourable terms."
An alternative to banks creating options on hedge funds is to use the same portfolio insurance strategy prevalent at the time of the 1987 crash. In that case, the bank mimics the return characteristics of an option by increasing exposure into rising NAVs and selling into lower values in line with the delta of an equivalent option. But, rather than guaranteeing investors the option return, the bank passes on the profits and losses on trading. Losses on this strategy in the initial period reduce the participation in any consequent upwards move and if the NAV falls through the guarantee curve, the product effectively shuts down. SocGen indicates that some three quarters of current business is in this product rather than the traditional zero-coupon, bond-plus-call-option structure.
Flying blind
Although operating prime brokerage, collateralised lending and structured products businesses in the same bank creates interactions between exposures that must be managed, there may be a greater risk in offering only structured products on hedge funds and effectively "flying blind". Certain issuers of structured products are notably absent from prime brokerage and collateralised lending.
Mr Mordecai highlights this as a risk. " It is always better to understand more of the hedge fund's capital structure, directly clear and settle trades and to hold some collateral," he says.
Although full transparency of the hedge fund's positions might not be provided to the trading books for structured products, the visibility of risk managers to the prime brokerage accounts and the holding of collateral provides some internal oversight and recourse in the event of failure. Societe Generale, with some $3bn outstanding in guaranteed structures but no prime brokerage activity, mitigates this risk by insisting on managed accounts in its own name with full position transparency via daily reports from the prime brokers of any fund on which it bases products.
SocGen's strategy
Rather than holding units in a fund, SocGen opens managed accounts with the hedge fund managers, whose positions mirror those of the publicly quoted fund. This means SocGen has beneficial ownership of the assets held by the managed account, which it can take control of, if necessary. SocGen's hedge fund management subsidiary, Lyxor, monitors these daily reports to ensure continued operation within the original risk budget, looking at leverage, credit quality of assets, and maximum concentration. Furthermore, SocGen uses its own administrator to verify daily NAVs.
Laurent LeSaint, director in the structured alternative investments group at SocGen, says: "Although our exposures are held in managed accounts, the objective is to be subject to the same sources of return as the publicly quoted fund. But, if a manager is continually breaching guidelines, we can remove trading authorisation on the managed account, withdraw money or assume control of the positions ourselves."
Martin Phipps, head of hedge funds at Gartmore, with whom SocGen operates managed accounts, says: "Before any significant inflow or outflow to or from any of the managed accounts, a dialogue would take place to agree some transition period so as not to have a deleterious effect on the fund. Allocations of capacity to a managed account in a particular strategy are made with these risks in mind. The different maturities, strike dates and leverage policies of Lyxor's numerous products significantly reduces the size of potential withdrawals in a drawdown situation."
Not all issuers of structured products operate in this way. Some have little or no transparency to fund positions, deal directly in the units of the fund on an infrequent basis with no guaranteed liquidity and are required to provide advance notice of dealing. Also, not all hedge fund managers are as circumspect in the proportion of their investor base that is derived from these instruments, creating a risk to the viability of the fund in any drawdown, when structured product providers will become forced sellers.
However, Mr Mordecai says position-level disclosure can put hedge fund managers at an extreme disadvantage. "To accomplish an alignment of incentives between hedge fund managers, banks and investors, appropriate aggregate disclosure standards are needed that do not unduly expose the hedge fund managers but provide adequate information to prime brokers and investors while ensuring investors get paid appropriately for the risks they are taking."
A recently published IAFE document puts forward recommendations for such standards as an alternative to full position disclosure.
Guarding against bad apples
Hedge fund governance varies widely. Some hedge funds have boards of directors, others are run by individual managers in virtual isolation. Lack of regulatory oversight creates a fertile environment for fraud and voluntary standards assume a certain level of integrity in the hedge fund community. An as yet undetermined risk to banks might come from a lawsuit in which a bank is found complicit in a fraud. Litigation continues in the case of the trustee of the Manhattan fund against its prime broker Bear Stearns, with a claim for $1.9bn in damages. Acceptance as a client is a separate decision to the terms on which a fund trades and the hedge fund market is notable for providing former fraudsters and incompetents with a second chance. A successful lawsuit could force banks to protect themselves and investors by screening out the bad apples.