What Hedge Funds Have Not Learned Since 1998

As I have read more accounts of the unfolding turbulence in the credit markets, and its spillover into equity markets, a few cardinal lessons continue to loom large.

First, as I noted last week in this post on risk, there exist arcane, exotic debt instruments which, in many cases, simply have no market. No bids are available, and, so, the effective 'market' price falls to zero.

Second, to paraphrase Wilbur Ross, a self-made tycoon via conventional buying, improving and selling mundane businesses, and CNBC's guest host this morning,

'when someone mentions two words, financial engineering, you know it's really an attempt to underprice risk.'

I could not say it any better. Rather than microscopically price risk correctly to the nth degree, CDOs have, instead, allowed originators to bury risk in amongst tranches of some portfolios of loans, and, in some cases, further mix them with other types of loans. That's not how the instruments were originally marketed, but that's how they now are used.

As we see in the current market turmoil, risk has come to be defined by qualitative factors, such as a security not being a CDO, or having anything remotely to do with housing finance.

Third, despite the post-LTCM crises shift away from leverage usage by hedge funds, such usage has, it turns out, returned with a vengeance. Nothing like an up market to give comfort to even institutional investors, and sustain unwise, lax policies.

By using leverage again, these hedge funds have been caught on margin calls while holding hard-to-price exotic securities. Usually CDOs or other debt instruments.

Fourth, when many smart people pile into an investment style by starting hedge funds, borrow money, and use similar, programmatic trading models to hedge and invest, it is not surprising that, when risk becomes important, and some of the instruments used by these funds to hedge suddenly lack 'markets' into which to sell. The result is for those funds to essentially lose most of their value.

My partner asked,

"But what else should they have done to earn returns? What other options did they have?"

My response is that they were always excess supply in the investment world. Many large, sophisticated institutional and individual investors will now lose a lot of money because they chased a chimera- outsized returns with no perceptible incremental risk.

It's unclear whether, except under purely bull market conditions, these funds, with their similar automatic hedging programs, ever really offered sustainable excess returns over the market, for the risk they incurred.

Put lessons three and four together, and you get the new hedge fund whiz kids borrowing to the hilt to buy and hedge exotic instruments. Then, as the credit concerns began to erode the value of those instruments, all of these funds began to try to unload the same types of instruments, causing a failure of markets for them. It's a sort of perfect storm for hedge fund mismanagement.

A few thoughts on the markets, risk, and fund management during a day in a week of yet more equity and debt market turmoil.

More to follow......