A humbling 1H 2021 for hedge fund investment – An allocator’s perspective on risk management
Feb-11，2022 | Vanessa Xu
This article was first published on FT Chinese.
Vanessa Xu: Co-Founder, Managing Partner, and Chief Investment Officer of VS Partners.
The calendar is nearly halfway through 2021 and the year already turned out to be the year to remember. We have seen biggest hedge fund blow up. We have seen hedge fund big shot beaten down by so-called amateur Wall-Street-Bets investors. We have seen most volatile stock rotation and most heated debate about direction of inflation on back of biggest US stimulus package, let alone a rampaging global pandemic in modern human history is still ongoing. It’s exciting to be in this market as investor but equally it’s challenging to navigate all different risks in this market especially for hedge fund strategies. As an example, in January concentrated short names got squeezed on back of GameStop aftermath then in March concentrated long names got penalised on back of Archegos violent unwinding. Some long/short strategies got hit on both sides. Ever since infamous LTCM collapse in 1997, people have realised that hedge fund risk management is not only about PnL and volatility, but also Liquidity, Leverage, Concentration and Counterparty risks (“LLCC”). How to learn from these extraordinary events and vigilantly due diligence and manage risks as an allocator investing in hedge funds?
Firstly, funding risk as one aspect of liquidity management is as important as the underlying market risk. Archegos is good example of this. The fund lost some money from its underlying equity trades for sure but what kills it is the failed margin calls to the fund and consequently the withdraw of funding and liquidity by the primary service department of investment banks. Funding or liquidity risk doesn’t need to be on very complex financial products. Some vanilla OTC products for example asset swaps simply based on stocks can give hedge funds many benefits. To name a few, the position doesn’t need to be disclosed compared to direct cash equity holdings hence the fund enjoys the secrecy that every hedge fund desires. Also the swaps can give them high leverage so that any returns can be amplified which is the secret recipe of hedge fund success. However, those leverage doesn’t come cheap. Primary brokerage departments of investment banks make billions of dollars every year for providing funding to leveraged hedge funds. Those funding are usually collateralized so that the banks can given themselves some insurance when things go bad. Also, the cost of funding tends to go up with the size of the trade and the volatility of the underlying assets, and when the borrowers creditworthiness and the quality of the asset goes down. Hedge funds only need to pay a small margin to obtain big equity gains if everything goes by the plan. But when things go bad for example if the trade losses money or the fund’s creditworthiness is in doubt, banks will require more margin to sustain the funding or even pull out the financing altogether. This vicious circle can kill hedge funds easily because if they lose money from the underlying position they need to sell their asset to make cash to meet margin calls, which in turn pushes the price of their asset even lower.
The investor’s risk manager needs to be cautious about liquidity and funding risk of the hedge funds. One needs to carefully measure the hedge fund’s funding needs and matches with the fund’s target return and volatility, more importantly carefully monitors any changes of these funding and leverage driven by above mentioned factors. If there is not enough buffer to cover the potential funding gap then the portfolio manager needs to be challenged.
There are multiple ways of measuring the liquidity buffer. For leveraged strategies usually the unencumbered cash held by the fund or financial asset that can be easily transferred into cash at any time e.g. short-term government bills and CPs is viewed as a source of liquidity buffer. This cash buffer usually measured as a percentage of AUM goes up with the level of leverage for example the relative value strategy that targets at micro distortion or mean reversion on massive trade sizes will need much bigger buffer than a directional strategy. A leveraged hedge fund long strategy will need a higher buffer than a fundamental long active strategy. To notice, this cash requirement is different from the volatility mitigation cash management process as the purposes of the two processes are different. The former is to meet potential shortfall of financing positions whereas the latter is to lower volatility with risk-free cash return in a distressed market.
Also very often risk managers look at how the funding is spent between own cash and borrowed cash because obviously the latter is more likely susceptible to liquidity withdrawal in market turmoil. Cash can be borrowed in various formats too for example through asset swaps as or loan, repo, margins etc. Depending on funding methods, collateral, underlying instruments liquidity, supply and demand of the funding, current prevailing borrow rate, borrower’s creditworthiness etc. the average costs of these different funding methods vary significantly. An investment risk manager needs to rely heavily on knowledge and experiences to carefully interrogate the investment managers’ borrowing methods and measure the costs against the fund’s liquidity assumptions.
Another aspect of the liquidity management is the underlying products of the strategy regardless of the funding methods. For example, a long only fundamental fund which only invests in liquid mega cap stocks will have less issue liquidating positions when required than another long only fundamental fund which invests in illiquid small cap stocks, even if their funding methods or average costs are the same (this is hypothetical because usually the average funding costs will be already adjusted for the underlying products). This product-level liquidity consideration adds another layer of complexity to the normal liquidity due diligence an investment risk manager usually does in the fund manager ODD process. However, this aspect is often overlooked because people tend to look at how the underlying products’ liquidity matches the fund’s liquidity/redemption terms in the prospectus but seldom consider how the underlying products market liquidity affects the fund’s funding liquidity. Seasoned risk managers who have seen such events would be able to put right judgement and action in place.
Leverage risk goes hand in hand with funding and liquidity risk. By the same token as above, risk managers can look at the liquidity risk from demands side as opposed to supply side as above discussed. They will typically measure the level of leverage deployed by the fund or the transaction and funding cost of the strategy. Leverage is a tricky measure because it has different meanings for different products and strategy. Gross/net NAV, gross/AUM ratios are typical leverage measures for vanilla strategies. Equity to margin ratio can be used for simple prime-brokerage-funded strategies. Gross/net 10y treasury equivalent duration or notional, gross/net 5y CDS benchmark equivalent duration/notional can be used by fixed income strategies. More exotic and leveraged strategies even use risk measures e.g. VaR and vol in leverage calculation e.g. VaR/AUM ratio, vol/AUM ratio. Combining with transaction and funding cost measures e.g. total turnover, average bit/offer, one-side investment spread, social ticker size vs. position size etc. risk managers try to estimate the overall demand from liquidity and funding side. This is very complex task that usually requires close collaboration between treasury, risk management, trading and finance departments of a firm.
Liquidity risk is also a very dynamic measure as it not only depends on the market conditions, the underlying product’s nature but also on how much the underlying products an investor holds. This gives rise to another important concept in risk management – concentration risk. Risk management should pay attention to both self-hold positions as well as market consensus and carefully measure those position sizes to overall market liquidity. GameStop saga is a good example of this. A sizable hedge fund only held limited size of short GameStop shares compared to the fund’s over AUM. However, the limited portion of a huge hedge fund on a small market cap company has proven to be a lethal combination for the hedge fund legend. To make things worse, GameStop is a favourable short name for institutional investors which means the risk is concentrated from both supply and demand perspectives. The stage is set up for a disaster to happen. Usually hedge funds take bets based on calculated risks, or put in more academic terms, probability-weighted returns. But this time, probability is not on their side as teamed-up retail investors took the other side and drove the stock price sky high. In fact, concentration risk is a dangerous thing because a very remotely possible event can sink the ship with just one strike no matter how good your probability estimation is. More importantly when situation changes, a liquid asset becomes illiquid or a two-way market becomes one-sided for whatever reasons, risk managers need to adjust her risk framework quickly to control for the excess liquidity risks.
When a concentration risk is formed within a hedge fund or strategy, its counterparty should get worried. This brings up another important risk concept – counterparty risk. Archegos was able to fund their equity trades using OTC swaps and was able to hide their massive position from any outsiders. Exactly because of that they were able to borrow enormous amount of money from unsuspicious banks which only have partial views on the trades that were done with the fund respectively. For example, one investment bank wouldn’t know how much swaps Archegos had done already with another bank on the same underlying position. If the banks knew that they wouldn’t have lent the money. Counterparty risk management is particularly difficult in the muddy hedge fund industry as every fund tries to keep everything secret. Also as mentioned the OTC nature of financial products make the measurement of counterparty risk almost impossible to handle properly which is the reason why teams of PhDs in the bulge-bracket investment banks’ risk management and quantitative analysis departments fail to foresee such event happening. That said, as an investor to hedge fund there are certain things that can be done by its risk management function to potentially mitigate such risks. For example, diligently monitoring the hedge fund’s concentration risks, hypothetically scenario losses and leverage ratio can help identify potential risks earlier.
Finally, risk managers or even just general investor of hedge funds ought to be always alerted on the tails no matter how successful the portfolio manager has been and what the fund’s sales team presents. A famous Wall Street saying summarizes this mentality well – a trader is as good as his last trade. As investor, we need to be objective, unbiased and vigilant!