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Hedge funds emerge from crisis with reputations intact

The economic crisis has shown that hedge funds did not pose a systemic risk to financial markets

A year on from the collapse of Lehman Brothers, lessons continue to be learned from the event and the ensuing economic crisis. One of these is that hedge funds, which in the past had been criticised for potentially posing systemic risk to financial markets via risky investment strategies, have emerged with their reputations largely intact.

According to Kevin Ewer, portfolio manager at Blue Ink Investments, labelling hedge funds as a threat to market stability failed to focus on the real issue at hand. “The Lehman crisis confirmed that systemic risk is caused by excessive gearing on a very large scale. While systemic risk could conceivably come from any geared investment vehicle, with asset size being such an important factor, only a few hedge funds would fit into this category. As the crisis proved, many banks had both the size and gearing on their balance sheets to pose such a threat.”

He says that the majority of hedge funds are smaller investment vehicles that take on modest gearing but whose chief risk comes from the investment strategy they follow. “These have either little or no impact on those not invested in the fund and therefore don’t pose a systemic risk,” says Ewer.

In South Africa there were no hedge fund blow-ups during the financial crisis, as local funds rarely, if ever, trade in the riskier instruments that impacted on the global hedge fund industry such as collateralized debt obligations(CDOs) and mortgage backed securities. “South African hedge funds tend to be fairly vanilla in terms of their investment strategies and the types of instruments that are traded,” says Ewer.

In fact, hedge funds delivered solid returns over the period of the financial crisis. According to the Blue Ink South African Hedge Fund Composite, which tracks the performance of around 100 hedge funds in South Africa, the average fund increased 2.33% in 2008 and is up 10.54% in 2009 to 31 August 2009, giving a total return of 13.12% over the 20 month period. By comparison, the JSE All Share index is up 18.27% for 2009 (to 31 August), but fell -23.23% in 2008, producing a return of -9.21% for the 20 month period.

Smaller South African hedge funds were also quicker to exploit opportunities rather than getting caught up in illiquid positions. “Within South African hedge funds this size factor was clearly evident, with the funds that struggled the most being the largest funds that could reposition themselves less quickly in the volatile markets,” says Ewer.

He adds that the role of the prime broker is also critical to a hedge fund. About 100 hedge funds had been using Lehman as a prime broker, so when the bank collapsed their positions were frozen. “The lack of a prime broker meant many offshore hedge funds were unable to conduct business. South African hedge funds did not suffer from this lack of support and were therefore able to execute their investment strategies.”

Ewer notes that the real systemic risk to markets was actually posed by the traditionally ‘safe’ banking sector. “Because they were regulated, banks were left to conduct their business in whatever way they saw fit. As the collapse of 2008 demonstrated, these regulations were either out of date or not being effectively enforced.”

Ewer says that despite the stability shown by most hedge funds during the economic crisis, they continue to be viewed with a degree of skepticism. “In order for hedge funds to become more mainstream investment products, we need proper regulation that is designed to protect investors but still allow hedge fund managers the freedom to express their investment ideas,” says Ewer, adding that the local industry is actively working with AIMA, ASISA and the FSB to find an appropriate solution going forward.

“Hopefully the current crisis has dispelled the myth that hedge funds are bad for markets, but there is still a lot of education required to get investors understanding what they are investing into and what strategies are being followed.”

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