Risk 2002 USA: Convertible arb funds could face liquidity risk concerns, says Soros Fund risk head

Speaking at Risk 2002 USA in Boston this week Satish said: “Over the last year, because convertible arb has done so well, there’s been a huge amount of growth in these funds and they all have the same positions. They all play the same names…they all look the same, quite frankly. If we ever come to a point in time in the market where we are selling, it’s a problem.”

Satish’s remark came as he was reviewing liquidity risk management approaches for long/short, macro, convertible arbitrage and fixed-income arbitrage strategy funds. Liquidity risk is the threat of losses from forced trading of large positions relative to market trading volume or losses due to an inability to sell assets deemed unlikely to maintain their value in a stressed market.

Satish described reliance on liquidity adjusted value-at-risk measures for hedge funds as impractical due to the way they are perceived by senior management. “People just don’t understand and believe in those numbers,” Satish said. “The key issue is how do you manage your liquid and illiquid positions, and that’s so specific to what you have in your portfolio. He added: “So, you might actually have a report where you say here is my VAR and here is liquidity-adjusted VAR – it doesn’t help you in any way at this particular point to be able to solve the problem of how you actually manage it under stressed times.”

According to Satish, hedge fund risk managers considering liquidity risk were best served by monitoring markets and their traders’ positions actively, and by maintaining adequate reserve levels and access to financing in the event large positions had to be sold. “When the whole market is selling, what do you do? You just hang tight and hope you can actually do it in a much more methodical fashion than trying to do the same thing everybody’s doing – just getting out,” Satish said.

Aside from being able to hold onto losing positions until after market stress subsides through financing from banks, Satish emphasised the importance of being able to neutralise positions through hedging, which bides a manager time until a better opportunity to sell emerges. Satish identified exchange-traded funds as a newer, growing and useful hedge for some equity positions.

Of the hedge fund strategies he reviewed, Satish described those involving equities – long/short and risk arbitrage – as least risky in times of liquidity strain due to the characteristics of equity markets. Convertible arbitrage strategies, where a manager buys a convertible bond, shorts the underlying stock and hedges out interest rate risk, are risky, according to Satish, due to their high leverage – one industry executive suggested leverage may be as high as five to 10 times – the large amount of funds chasing few convertible issues and the losses likely from having to sell or finance such positions in the event of market turmoil.

Soros Fund Management, believed to have around $11 billion in assets under management, is known for making large bets on the direction of currencies, commodities, fixed income and equities as driven by macroeconomic conditions.

Satish described the size of such macro trades as “phenomenal”. But he added that bank consolidation has made risk capital less available to macro funds in the past few years. Satish described risk management of macro trades as heavily emphasising reserves. “You just have to kind of say 'these are my reserves: I can actually lose this much and I’ll be fine'.”

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