Veryan Allen has a neat riposte to anybody who claims that
the meltdown at Bear Stearns’ credit funds shows how dangerous hedge funds can
be: the Bear Stearns funds weren’t
hedge funds!
Allen has a classic ex post definition of what a hedge fund is. Real
hedge funds, he says, make money in up markets and in down markets. So if you
lose lots of money in a down market, you weren’t a hedge fund at all. It all
seems wonderfully sophistic, but Allen does have two very good points.
Firstly, a hedge fund should not be a "leveraged beta bundler" –
something which levers upside returns at the cost of levering downside returns
as well. And secondly, you can’t hedge the exposure you have to illiquid instruments
by buying a more liquid offsetting position.
Bear Stearns was leveraged long CDOs of illiquid securities and "hedged"
by shorting liquid ABX indices. As with similar problems in the past, BSC
was long illiquid, short liquid. If a fund is leveraged and can only sell
to a limited number of counterparties who KNOW it has a problem, getting out
becomes difficult…
There is nothing inherently wrong with investing in "untraded" assets
provided the risk-adjusted returns are sufficient to compensate. In bearish
credit conditions ideally you usually want to be long the liquid and short
the illiquid but weaker credit funds and less experienced managers do the
opposite…
Just as with LTCM, being long the illiquid and short the liquid works well
until the market reverses and then years of consistently positive months get
given back in one massively negative month. Leverage, liquidity and valuation
risks are ONLY worth taking if you are compensated for those risks and plainly
this was not the case.
The irony here is that on this logic, which is unassailable, investors in synthetic
CDOs are actually much better off than investors in the "real thing".
A synthetic CDO is made up of liquid and unwindable credit derivatives, and
so long as the manager of the CDO has a halfways decent risk management system,
it shouldn’t find itself with sudden unexpected losses, since it’s relatively
easy to mark the contents of the CDO to market. On the other hand, a CDO filled
with untraded tranches of illiquid mortgage-backed securities might implode
quite suddenly.
Of course, all of these instruments, synthetic or not, are still much more
illiquid than even the illiquid securities that LTCM was investing in (Russian
GKOs, off-the-run Treasury bonds, that sort of thing). Liquidity is relative,
and the mortgage-backed CDS market has yet to be tested by a sustained bout
of bearishness. For the time being, however, I bet that Ralph Cioffi
is wishing he’d had more derivatives in his fund, not fewer.