Saturday, February 21, 2009

Smoke and Mirrors: The Bend Some and Hedges Effect (2009)

From the February 2009 issue of the Socialist Standard
The fiasco surrounding the $50 billion hedge funds run by Bernard Madoff has been another illustration of the current instability at the heart of capitalism’s financial apparatus.
Hedge funds try to bend the normal financial rules of the market in whatever way possible, though it appears Madoff went too far in what could be the world’s biggest ever fraud. A massive investigation is under way into how Madoff set up and maintained a giant ‘Ponzi scheme’. These schemes take their name from Charles Ponzi, an Italian immigrant to Boston in the US who, during the early 1920s, set about spreading rumours of lucrative investment opportunities he was involved in. These supposedly guaranteed what the Wall St Journal exposed as impossibly high returns, when in reality most of the underlying investments did not exist and Ponzi merely took people’s money and used some of it to pay dividends and other returns to existing investors, while creaming the rest off for himself. This was able to continue as long as new investors were attracted to the schemes. When the flow of new investors stopped, the schemes imploded.

Although an investigation by the Securities and Exchange Commission in the US is currently taking place into the precise nature of Madoff’s actions, he has apparently confessed that the steady above-average returns that characterised his operation did not reflect the underlying reality and that, over time, his funds became an elaborate sham. There is now a mammoth scramble by wealthy investors, charities and financial institutions to try to recover whatever little may be left of their original investments, with these investors notably including funds managed (or held in custody) by major banks like UBS, HSBC and RBS. Indeed, Bank Medici reportedly had $3 billion invested with Madoff and because of this has now been taken over by the Austrian government (Financial Times, 3rd January).

Hedge funds
The Madoff affair is in many respects but the latest (and most spectacular) disaster to afflict the little-understood world hedge fund sector. Until last year, the most infamous previous case of a financial disaster involving a hedge fund was in 1998 when what had become the world’s biggest hedge fund at the time – Long-Term Capital Management – went bust. This had been headed by a team that included two Nobel Prize winners for economics, experts in the pricing and risk-assessment of complex financial instruments. But after years of stellar returns in the 1990s the fund collapsed and had to be bailed-out by a consortium of 50 investment banks put together by the then Chairman of the Federal Reserve, Alan Greenspan. The banks had already invested so much in LTCM (and loaned it so much money) that their own capital would have been seriously jeopardized by the losses incurred and Greenspan had to step in to help them in a way that was a precursor of recent actions during the 2008 financial crisis.

The collapse of LTCM demonstrated that those who viewed hedge funds as an esoteric but peripheral phenomenon were living in the past. Hedge funds had by this time become a hugely significant, if secretive, part of capitalism’s financial operations, with the ability to exert an influence on markets well beyond that of many governments. This had previously been demonstrated to those paying attention by George Soros and his Quantum Fund, which in 1992 had made $2 billion betting against sterling in the European Exchange Rate Mechanism, forcing the UK out of the ERM and metaphorically ‘breaking the Bank of England’ in the process, with government intervention unable to stop the slide of sterling against the deutschmark.

So, given the ascendancy of hedge funds in recent years and the recent media fascination with them, what do they really do and why are they deemed to have so much financial power?

Hedge fund strategies
While the public conception of hedge funds is that they are highly risky investment vehicles that aim at spectacular returns for their investors, this isn’t entirely true in every respect. Indeed, hedge funds gain their name from strategies aimed at ‘hedging your bets’, so that in theory the risk associated with one activity can be mitigated, at least in part, by others. Most hedge fund managers are not interested in relative performance measured against an accepted benchmark. In this sense, they do not aim to beat an index like the FTSE 100 or the S&P 500 in the US in the way that other investment managers running more conventional operations like unit trusts and investment trusts do (whereby, say, an annual return of minus 20 per cent would be considered a good relative performance if the market had fallen by more than 30 per cent as it did last year). Instead, hedge fund managers generally seek ‘absolute returns’, which are positive returns in any sort of market conditions.

Most, though certainly not all, hedge fund strategies are equity-based involving stock market investment, and hedge funds generally aim to try to secure returns noticeably better than the long-term annual average return from shares (which in most major western countries has tended to be in the 8-10 per cent range). This is another reason wealthy investors find them so attractive.

The strategies adopted by hedge funds to achieve this type of performance in all market conditions fall into various categories, the most common of which are the following:

  • Long/short equity, which involves buying shares in some companies in the hope they will go up (‘going long’), but shares in other companies in the hope they will fall (‘going short’), thereby hedging the bet. Going short usually involves borrowing shares and immediately selling them only to buy them back cheaply later when their price has fallen so that they can be returned to the original lender and the difference kept as profit. Sometimes this type of long/short strategy involves ‘pairs trading’, such as going long on BP but short on Shell in the belief that the former oil stock is undervalued compared to the latter.
  • Arbitrage, based on a variety of techniques and strategies used to exploit market pricing inefficiencies (for instance, a company like Shell is quoted on more than one stock exchange and there can be temporary discrepancies in the price quoted in Euros in Holland compared to the price quoted in sterling in London). Fixed income arbitrage funds try to exploit pricing inefficiencies in bond markets and this was the main strategy used by Long-Term Capital Management until its collapse. LTCM took the view, backed up by various mathematical models they had developed, that bond yields tend to converge over time. More often than not this is true, though not always – as they were to find out during the Russian debt and currency crisis of 1998 when traders took flight from Russia, sold risky investments and bought into the relatively safety of US Treasury Bills instead.But LTCM had bought low-priced and high-yielding Russian government securities, while at the same time selling short high-priced and low-yielding US Treasuries, in the expectation that their yields would converge over time. This was because they assumed that investors attracted by high-yielding Russian securities would buy them en masse, push their prices up and so reduce their yields, while selling the relatively unattractive US Treasuries, raising their yields. Charles Geisst pointed out in his excellent Wall Street: From Its Beginnings to the Fall of Enron that ‘the idea of converging yields evaporated overnight as the Russian obligations fell precipitously in price and the Treasuries gained as a result of the flight to quality. The fund was on the wrong end of both sides of the trade’ (p.380), a calamitous end for the Nobel Prize-winning economists.
  • Event-driven strategies, which can involve buying shares in the expectation that a company merger or takeover is likely, or which can involve buying into distressed assets (these are avoided by most investors so there is more likelihood of significant mis-pricing and the opportunity to buy assets at a knock-down price). Often hedge funds will buy the debt of a distressed company as a prelude to taking it over and/or liquidating it for a profit.
  • Macro-strategies, which are based on taking positions on what is likely to happen in the global economy. George Soros’s Quantum Fund has specialised in these macro-strategies, taking huge, credit-fuelled bets on the direction of currencies and commodities, for instance, and in doing so exerting more economic power than many governments can muster.
  • Quant strategies, which are based on complex mathematical models, and which can involve elements of the other strategies named above as well as short-term trading designed to profit from minute-by-minute and second-by-second price fluctuations.
  • What all these hedge fund strategies have in common is that they involve speculation to varying degrees as opposed to investment for the long-term, and typically involve significant amounts of leverage too (hedge funds often borrow in multiples of many times their own value as a way of maximizing their returns - for example, returns from arbitrage activities would often be minute if it wasn’t for the amount of leverage used). And unsurprisingly, these are two of the main reasons hedge funds are often considered to be risky, if not unstable, influences within the market economy.

    Hedge fund structures
    In truth, the risk hedge funds present to the operation of the market economy’s financial system isn’t solely because of what they do, though it is true enough that regulated investment vehicles like unit trusts and investment trusts are legally unable to adopt many of the strategies hedge funds use. The main issue with hedge funds, exposed once and for all by the Madoff scandal, is that they are largely unregulated entities for the secretive and super-rich, and as such are open to all sorts of abuses, attempting to bend the investment ‘rules’ at will under the guise of innovative practice.

    Most hedge funds are restricted to investors – who on investing usually become limited partners – with at least $1,000,000 (excluding their main residence), i.e. they are for capitalists only. They are also limited in terms of the number of investors who are allowed to join the fund. This is to avoid the restrictions and regulations placed by governments on other investment vehicles designed for mass participation and has been a way for hedge funds to slip ‘under the radar’ of the regulators. Most hedge funds – registered offshore for tax reasons and run as private investment partnerships – are covered by little in the way of investor protection and are barred from advertising or being sold to retail investors. Aside from withdrawing their investments (there are often restrictions on this too) hedge fund investors have little practical control over the managers, usually even less so than other collective investment vehicles like investment trusts which have shareholders and an elected board of directors answerable to them and which have to issue transparent annual reports, regular trading updates and so on.

    The basic hedge fund structure appears to have changed little since they first appeared in the early 1950s, having been pioneered principally by Alfred Winslow Jones in the US, though many others – such as Warren Buffett before he developed his huge publicly quoted Berkshire Hathaway investment vehicle – established comparable private funds at a similar time. Annual management fees are high, typically 1 or 2 per cent of capital under management, with another 20 per cent of annual returns over and above an agreed threshold, explaining why in recent years many high-flying fund managers working for the big investment banks have been so keen to leave and set up their own hedge funds.

    The role of hedge funds
    Hedge funds, like private equity, have emerged in the present economic crisis as some of the ‘bad guys’ of the financial world, almost as if a capitalism without them would somehow be sane and humanitarian. Small investors in retail banks in the UK that have had to be nationalised or merged railed last year against the hedge funds for shorting bank stocks, driving their prices ever lower. It was clear that this would have happened anyway though as was illustrated when the share price slides didn’t stop when the shorting of financial shares was prohibited by government order.

    There is always a place in capitalism for scapegoats, especially those as rich as most hedge fund managers have been (and as unpleasant as some of them no doubt are). But this detracts from the real issue which is the instability and chaos that lies at the heart of the money/prices/profits system itself. Capitalism without hedge funds is just as brutish and nasty as capitalism with them – and the irony is that if you accept the rationale of the capitalist economy, hedge funds and other speculators, contrary to much popular opinion, play a useful role.

    Capitalism’s financial markets are the lubrication for the entire capitalist economy. These markets depend on liquidity and frequent trading to accurately match buyers and sellers at any one moment in time. If trading is thin, this matching of trades becomes difficult if not impossible, whether in shares, bonds, commodities, or more complex financial instruments. If, for example, shareholders investing via the stock market all used a ‘buy and hold’ strategy and didn’t generally sell their shares for long periods after buying them, the equity markets would be stifled and trading difficult. This is why hedge funds and speculators more generally perform a useful role for the system – they are one of the main ways of ensuring sufficient liquidity for it to be able to function properly.

    Their growth in size and influence, especially in the last 15-20 years, has been phenomenal, explained by their potential attractiveness to capitalist investors aiming for a steady but above average return, and their attractiveness to fund managers because of their flexibility and fee structures. The number of hedge funds in existence now runs into the thousands, with London’s Mayfair being nick-named ‘hedge fund alley’. According to the Financial Times (31st December), hedge fund assets under management have grown from less than $50 billion in 1990 to around $1,900 billion last year, making them a hugely significant economic force.

    The current financial turmoil, however, has seen the biggest outflow of assets invested in hedge funds for decades, a sum estimated at $400-500 billion from January to November 2008. Lack of credit and high interest rates have meant that a great many hedge funds have had to de-leverage, reducing their debt as quickly as they can and selling their assets at the best prices they can get in falling markets. And as investors withdraw their money on the back of faltering returns, this has had the knock-on effect of hedge funds also having to sell their assets to meet redemptions, creating a vicious downward spiral for equity prices in particular, called ‘forced selling’. This was the cause of much (if not most) of the massive waves of selling on world stock markets last September and October, with quite unprecedented levels of market volatility over a sustained period.

    Due to this de-leveraging and forced selling at low prices, several hedge funds have already gone bust and there will surely be more to come. In addition, because they were so highly leveraged, the unpredictable volatility in equity, bond and credit markets has ensured that some funds have just folded under the onslaught, including some of the macro and quant funds that should, in theory, have been able to capitalize on these situations.

    As hedge funds operate in such a competitive market, those that don’t perform get shut down or merged with others (so much so that around 60 per cent of hedge funds are no longer around within five years of their inception). The financial crisis will almost certainly ensure that this figure increases further. Also, there are already indications that hedge funds will be the next target of the regulators and so it would seem that the great hedge fund bonanza is over, at least for now.

    As for Mr Madoff, he will have done the cause of hedge funds no good either as their lack of transparency has been illustrated as starkly as it could possibly have been. Many capitalists will no doubt now be looking elsewhere to invest their wealth – so long as another Mr Madoff hasn’t made off with it first.