Caught in the headlights

In many ways, the sub-prime calamity is no different from the dotcom, Asian and junk bond debacles that preceded it. As the saga unravels, institutional investors seek refuge in simpler instruments. The difference this time around, though, is that the products were much more complicated than in the past and pension funds may take their time plunging back into riskier waters. They are also advised to put fund managers through their paces and start asking more probing questions.

“The events that have happened since the summer are a sobering reminder that we have moved away from buying exchange traded products into over-the-counter instruments,” says to David Jacob, head of fixed income at Henderson Global Investors. “As a result, we are more beholden to liquidity provided by the investment banks and when this dried up, it made it difficult for fund managers to change their strategies and effectively manage money.”

Not surprisingly, the level of risk has shot to the top of the agenda across all asset classes. As Philippe Carrel, executive vice-president and global head of business development at Reuters Trade and Risk Management, puts it: “The new motto is that if you cannot price the instrument, drop it. The sub-prime crisis has changed the way investors handle credit and there will be a new paradigm going forward. Investors will now need proper risk management and valuation tools. I think in the short term, all assets are under review.”

This does not mean the end of the diversification theme that has gained momentum over the past six years. “The trend towards alternative assets will continue but investors will need a better understanding of the products, the risks and whether they can achieve their specific targets,” says Guy de Blonay, manager of the New Star global financials fund. “The complexity that produced the high returns also hid the risks and it was only when the system started to crack, that the problems came to light.”

This is especially true of quantitative and other hedge fund strategies as well as money market funds, all of which were caught in the credit crunch headlights. Although hedge and quant funds have always elicited mixed views, pension funds, corporates and insurance companies were surprised the most by the losses in money market funds, often seen as low-risk, safe-haven investments.

In fact, over the past three years, money market funds had become fashionable places for investors to park their cash. In the US, assets reached a staggering $3trn (€2.04trn), while in Europe they gathered an impressive $500bn, according to figures from Lipper Feri, the fund data provider. While triple-A rated funds always had a following, many were increasingly attracted to so-called ‘dynamic’, ‘absolute performance’, ‘absolute return’ or ‘enhanced’ money market funds, which generated higher returns - typically 50bps above inter-bank borrowing rates - for a little extra risk. Assets were spread among a range of short-term bonds, derivatives, currencies and arbitrage on credit instruments. Few investors realised, though, just how far down the credit curve some of these funds had ventured.


The extent of the problems were first revealed in Europe last 2007, after Axa Investment Managers announced that two of its ‘dynamic’ money market funds, which targeted returns of LIBOR plus 50bps, had invested about 40% of their assets in sub-prime mortgages in the US. Although none of the funds’ holdings, worth about $700m, had been downgraded, the funds’ value had fallen more than a fifth in the month and the French insurer was forced to use its own money to match any redemptions by investors.

More recently, State Street, which manages $2trn, has been in the spotlight due to lawsuits tied to losses in its enhanced fixed income funds and other conduit vehicles that made the wrong bets on mortgage-and asset-backed securities. William Hunt, chief executive of State Street Global Advisors, resigned at the start of the year and the firm also put aside $618m to cover legal and other costs related to its sub-prime mortgage portfolio.

The move by State Street highlights the legal challenges that lie ahead for financial firms that were involved in the origination, packaging and sale of complex mortgage securities. A recent study published by the Stanford Law School and Cornerstone Research found that the number of securities lawsuits filed in the US in 2007 jumped 43% from the year before. The figure is likely to increase this year due to the sub-prime mortgage crisis.

Despite the negative publicity, market participants emphasise the importance of differentiating between triple-A rated cash funds, which invest in fairly low risk securities such as short-term deposits, commercial paper, certificates of deposit and floating rate notes, and enhanced cash funds. The questions that pension funds need to ask may appear obvious but it is essential that they dig beneath the packaging.

Jacob believes that the diversification inherent in money market funds and the yields are still better than leaving the money in an overnight deposit account. “However, just because a triple-A rating is slapped on them, it does not mean that there are no complex instruments or asset backed securities in them,” he adds. “This is not a bad thing as long as the fund managers have the resources and capabilities to analyse them. Pension funds must also understand that ABS are still an effective way to slice and dice cash flows to suit different investor requirements. They have been around for a long time and the current problems are due to lax credit standards in lending.”

Understanding what exactly is in the tin also applies to quant funds. After years of stellar growth, their image took a battering in the summer and many participants blamed them for causing the unprecedented volatility in August as a number of hedge funds sold off the same US stocks simultaneously. Despite their previous performance, the sub-prime crisis highlighted that some of these models, whatever their complexity or relevance, cannot adapt to brutal sharp shocks.

While some funds have recovered, industry estimates show that the amount of money managed by quant funds has plummeted by up to 40% in the past six months. The market also witnessed its first casualty with the closing of San Francisco’s GMN Capital’s flagship fund. It had dropped 18.8% year-to-date at the end of November while assets plunged to about $450m from a high of $1.2bn less than a year before, due mainly to investor redemptions.

The general consensus is that household name firms such as AQR Capital Management and Renaissance Technologies have the scale and depth to rebound from occasional extreme hits and resulting investor redemptions, but smaller or newer firms may not weather the storm. Graham Martin, managing director of Optima Investment Management (Europe), a fund of hedge funds firm that manages $6.3bn, advises pension fund managers “to do their homework and proper due diligence before investing in quant or any other type of hedge fund strategies. They need to figure out what is in the box and not just go by the wrapping. The basic premise should be if they can’t figure out how the manager is achieving the returns, then they should not be investing.”

Robert Hayes, head of strategic advice services at BlackRock, also believes that, “pension funds have to be a bit more realistic. Quant funds are not a panacea. The models are immensely powerful tools if you understand what is in them and use them sensibly. However, you cannot buy history and just because something performed well in the past, you cannot expect it to perform well in the future.”

Nicholas Verwilghen, partner and head of quant research at EIM, a fund of hedge fund with $14bn of assets under management, adds: “The question needing answering is, what lessons have been learned? I think radar screens need to be developed to show quant managers where the crowded trades are so that they know what the rest of the industry is doing and how they can benefit from those moves.”

As for the rest of the hedge fund universe, the structure of the strategy, the track record of the managers and the internal resources are all important factors. Flexibility is also key. Verwilghen notes: “Hedge fund managers need to ensure that they play the game and do not become the game. Investors have to question whether there is sufficient capital in a fund that will enable the manager to take advantage of any opportunities. It is no good pursuing a strategy that will take six months if redemptions are allowed within three months.”


Overall, pension funds are advised to take the fund of hedge fund route, particularly those who are embarking into the asset class for the first time. The theory, of course, is that they offer a diversified pool of strategies, thereby spreading the risks and returns. Although they suffered the worst image crisis since 1998, data at the end of last year from Hedge Fund Research (HFR), the Chicago-based data compiler, revealed that the average fund was likely to beat the stock market indices for 2007.

Looking ahead, in terms of strategy, distressed securities are expected to be all the rage, according to a survey conducted by HFR, which canvassed some 41 hedge fund managers, with about $227bn under management. Next on the list were global macro funds, which bet on global market trends, followed by long-short equity strategies.

The fallout from the sub-prime debacle may continue for some time. And with a possible US recession, this year looks unlikely to be a stellar one in terms of returns. So astute investors will be looking to make sure that they use their position as long-term investors to the best possible advantage. They will be asking tough questions of their investment managers in 2008.

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