Turbulent times for hedge funds

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The rollercoaster ride hedge funds have been on since September 15, 2008 just keeps going and going. Markets continue to yo-yo their way from day to day. Hedge fund returns as tracked by the main indexes are not quite as robust as many had hoped.

The eurozone continues to try to convince the world its bailout plan is a goer while Germany has broken ranks. The destabilising effect of the euro’s problems on the rest of the world is a local problem or a global one, depending on your perspective.

While the EU has a worrying tendency to consider itself the centre of the known universe, this time the knock-on effects of the euro’s problems could instead make it the epicentre of another systemic failure that makes Lehman look like a walk in the park.

The special purpose vehicle (SPV) formed to bundle up the debts of Greece and others looks suspiciously like a gigantic and concentrated version of the collateralised debt obligations that packaged and masked the weakness of the subprime mortgage debts.

The irony of this has not been lost on the markets. A website poll by Hedge Funds Review (still running as we go to press) confirms that few want to ‘rate’ the SPV as AAA and a growing percentage see it veering into junk bond status.

What is more worrying is the fact the global markets do not appear to think the joint efforts of the eurozone members and the International Monetary Fund is enough to stop the exteriorisation of member states’ finances. While it is clear the fate of Greece, Spain, Portugal and even Ireland would have little real effect, the lynchpins of the eurozone – Germany, France and Italy – may not be enough to keep the union together. Italy is already on the list of basket cases.

There are growing market rumours about France. Germany meanwhile has decided to start behaving like every other member state and pursue its own national interests above that of the EU. Hence its shock prohibition on the naked short selling of eurozone government bonds, credit default swaps (CDS) on those bonds and 10 German financial stocks announced by the securities regulator, Bundesanstalt für Finanzdienstleistungsaufsicht (Bafin). This move shook global markets. The apparent reasoning behind extending the ban to euro swaps is naked currency swaps contribute to negative trends that result in the further destabilisation of the eurozone.

The message is clear: naked derivatives trades where the underlying is the euro are undesired.

The unilateral measures taken by Germany on the sovereign debt markets, both on the short selling of sovereign bonds and CDS, are counterproductive, inconsistent and liable to hinder European growth.

Further evidence that Germany is out to protect itself regardless of the consequences for the rest of the union come in the form of unconfirmed but persistent reports that Germany is considering printing a deutschmark euro, differentiating its currency from the ‘other’ euros. This idea was floated at the beginning of the Greek crisis. Whether it is even possible is an intriguing question. However, the real question is what would happen if the eurozone really did implode. The way the treaty is written, such an event could start to unravel the EU itself. Neither event would be a good thing.

On top of this uncertainty and uneasiness is heaped even more of the same. A new level of complexity and uncertainty in the shape of politicians is also making markets jittery. Pre-Lehman the financial world seemed fairly immune to political interference. There were the odd pot-shots at banks, brokers and hedge funds but nothing too serious.

Now it is open season on almost any aspect of the financial world. This is not only confusing the markets but having a bad effect on hedge funds. Returns for May look likely to continue to decline or totter close to negative figures. It is not as bad as the worst month (which followed Lehman’s collapse) but it is giving investors pause for thought, just as it seemed money would come back into funds in a sustained way.

Costly confusion

Although the EU is still dithering on how to react to the German’s unilateral shorting ban, the likely outcome is some sort of further disruption to the way shorting is conducted. This is not good for hedge funds. While it is possible to find ways around bans and alternative ways to short, it does add costs and slows down managers. Bans on shorting are also bad for the markets, pulling out liquidity and potentially allowing inefficiencies to grow wider.

On top of this is, of course, the looming threat of more regulation. While the US seems to be moving towards measures that impact the banking sector more than hedge funds, the fallout from the financial legislation could work in favour of fund managers, particularly if proprietary trading desks shrink and the trading environment becomes less crowded. There have already been a number of former traders exiting banks voluntarily or involuntarily and many have entered the hedge fund industry. This could be a boost to the industry with some of the brightest and best from the banking world moving into hedge funds.

On the negative side, however, remains the uncertain outcome of legislation coming out of the EU. Politicians there are keen to mitigate Germany’s unilateral move on shorting and are discussing various ideas on imposing an EU-wide ban of some sort.

That would be a colossal mistake but true to form for the EU in getting it wrong. The unintended consequences of such a ban could potentially be bad for London, which at present accounts for around 75% of sovereign CDS trading. The net result of any ban would certainly be to move the action to New York but not stop it.

At the same time political knee-jerk reactions are still prevailing in the EU and likely to become even more erratic as the eurozone crisis deepens and debate continues on such ideas as a banking tax and other measures the EU believes it can impose to guard against another market meltdown.

In the midst of this continuing turmoil, there are some interesting bright spots. One is the unexpected announcement from Man that it is buying GLG. The deal, if it goes through, would make Man the largest hedge fund manager in the world. Quite an achievement and one that could presage further mergers and acquisitions within the industry.

The recently announced F&C purchase of Thames River is another example of how the industry is looking at ways to leverage various aspects of the alternatives industry to create bigger and more profitable entities that can also tap into new sources of investment.

The final outcome, as with the legislation and general financial mayhem, remains unclear. Whatever happens, it seems likely the summer months will continue to be volatile and unpredictable. Summer holidays may be spent with BlackBerries at the ready.

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