Tough October for listed hedge funds - Cazenove

The HFRI Fund Weighted Composite was down 5.4% in September as hedge funds experienced their worst month since the Russian debt crisis.

And the large drawdown is continuing in October, with the investible HFRX Global index down 9.0% to 24 October, according to absolute return funds provider Cazenove Capital Management.

Writing in the firm’s October listed hedge fund dispatch, Cazenove analyst Tom Skinner said:

“In face of collapsing NAVs, limited buybacks and heightened performance uncertainty, discounts in the listed sector have moved sharply wider. Several funds are now in danger of breaching discount control mechanism triggers.”

With many listed fund of hedge funds trading on discounts in excess of 20%, and serious concerns over their ability to support narrow discounts in the short to medium term, the sector is coming under great pressure, Skinner said.

“As the AUM of the wider hedge fund universe contracts, we believe that the listed sector will not be immune. Several funds, some possibly trying to pre-empt discount control mechanism triggers, are winding-up, offering exit opportunities or restructuring their funds, including F&C Event Driven, MW Tops, CMA Global, Close Man Hedge and Aida.

“Several more funds are on the ropes, including Gottex Market Neutral, Dexion Equity Alternative and Dexion Alpha, and we believe that many of the listed fund of hedge funds do not have the critical mass to withstand this period and that the universe will shrink." 

Skinner also notes: “FOHFs that are winding-up, offering tenders or facing the prospect of continuation votes are generally those that have tried to differentiate themselves from core multi-strategy FOHFs through gearing, more adventurous strategy exposure or a more narrow strategy focus. In design and/or execution these funds appear to have failed to meet investors’ expectations and requirements.”

The despatch suggests that several funds appear to have been caught in the same crowded hedge fund trades and that in the absence of liquidity, the costs of extricating from a trade have also ballooned.

“The ability to hedge a trade has become more expensive and more difficult, given concerns over counterparty exposure. Deleveraging across hedge funds continues, and this continues to erode performance,” Skinner said.

There has been a great deal of speculation about the extent of hedge fund redemptions and the shrinkage of hedge fund AUM, with expectations of a 25%+ decline in AUM by year-end.

Many redemption requests will be submitted at the end of the third quarter for redemption at 31 December, but more redemption requests are likely to be submitted this week for 60 day notice period funds.

“Many of these requests have come from fund of funds and may be, to some extent, pre-emptive, “Skinner said. “Many fund of funds face a liquidity mis-match between the terms they offer investors and the terms on which they invest, thus necessitating them to make investment decisions on the basis of expected rather actual investment flows. Furthermore, given the volatility of returns and the increased risk of gates or lock-ups being imposed, investors are likely to want to maintain maximum flexibility. In many cases, submitted redemption requests can be cancelled before the redemption becomes due.”

Funds of funds are also being affected by the extreme currency moves:

“The dollar has gained around 15% this month against sterling. Funds owning a high proportion of dollar denominated assets that hedge into sterling will have seen the sterling value of these dollar assets rise by 15%, ignoring for the time being the decline in the underlying assets. This, however, will have been offset by a dollar hedge on which the fund will have made a loss. But this loss must be settled in cash, while the offsetting gain is in the form of illiquid hedge fund assets.

“This would not normally be a problem as these could be redeemed relatively easily, but with gates coming down and lock-ups lengthening, the liquidity of the underlying portfolios has deteriorated. Moreover, the poor performance of the underlying assets this month could mean that a number of funds have been over-hedged (i.e. sold more dollars than they needed to), which would exacerbate the problem. Most funds of funds have overdraft facilities to tide them over, but it is possible than one or two funds, including in the listed sector face their own liquidity crunch.”

A number of the larger single managers such as Third Point, MW Tops and BH Macro/BH Global have all reduced net and gross exposure as equity funds try to preserve capital.

“MW Tops’ contributors have been guided to reduce risk and concentrate their ideas, as the volatile markets make it harder to make successful calls. In general, speakers [at a recent Cazenove conference] thought that equity markets continue to be detached from stock fundamentals, macro (such as policy). technical factors and sentiment key drivers.

“In this environment, managers are not taking much investment risk but seek to remain engaged. Gross exposure is just as important as net exposure in these types of markets. However, the withdrawal of investment bank prop desks has expanded the opportunity set for fixed interest arbitrage strategies of the type employed by BlueCrest and Brevan Howard.”

Skinner believes that because firms are reluctant to offer to repurchase in scale, concerns over NAVs, blow-ups and liquidity restrictions on the underlying are likely to keep discounts at meaningful levels:

“However, discounts in excess of 25% seem, in our opinion, to be extreme with a range of 10-15% seeming more appropriate. As panic subsides, we expect some funds will be more willing to buyback in greater size, subject to available cash, helping discounts to stabilise at around that level in the near term.”