hedge funds and repo

Hardly a week goes by without the implosion of a hedge fund. Last week it was Carlyle Capital, with an astonishing $31 of debt for each dollar of equity. But we should not be surprised. These collapses are inherent in the hedge-fund model. It is even conceivable that this model will join securitised subprime mortgages on the scrap heap. Getting away with producing adulterated milk is hard; getting away with an investment strategy that adds no value is not. That was the point made by John Kay, in a superb column last week (this page, March 11). With the “right” fee structure mediocre investment managers may become rich as they ensure that their investors cease to remain so. Two distinguished academics, Dean Foster at the Wharton School of the University of Pennsylvania and Peyton Young of Oxford university and the Brookings Institution, explain the point beautifully*. They start by asking us to consider a rare event – that the stock market will fall by 20 per cent over the next 12 months, for example. They assume, too, that the options market prices this risk correctly, say at one in 10. An option costs $0.1 and pays out $1. Now imagine that we set up a hedge fund with $100m from investors on the normal terms of 2 per cent management fees and 20 per cent of the return above a benchmark. We put our $100m in Treasury bills yielding 4 per cent. We also sell 100m covered options on the event, which nets us $10m. We put this $10m, too, in Treasury bills, which allows us to sell another 10m options. This nets another $1m. Then we go on holiday. There is a 90 per cent chance that this bet will pay off in the first year. The fund then grosses $11m on the sale of the options, plus 4 per cent interest on the $110m in Treasury bills, for a handsome 15.4 per cent return. Our investors are delighted. Assume our benchmark was 4 per cent. We then earn $2m in management fees, plus 20 per cent of $11.4m, which amounts to over $4m gross. Whatever subsequently happens, we need never give this money back. The chances are nearly 60 per cent that the bad event will not occur over five years. Since the fund is compounding at a rate of 11.4 per cent a year after fees, we will make well over $20m even if no new money is attracted into this apparently stellar enterprise. In the long run, however, the bad event is highly likely to occur. Since we have made huge profits, our investors have paid us handsomely for the near certainty of losing them money. The immediate response may be that so naked a scam is inconceivable. Well, imagine a fund that leverages investors’ money by borrowing massively in short-term money markets in order to purchase higher-yielding paper. Assume, again, that the premium gives a correct estimate of the risk. With sufficient leverage, this fund, too, is likely to make profits for years. But it is also very likely to be wiped out, at some point. Does this strategy sound familiar? It certainly should by now. We can identify two huge problems to be solved. First, many investment strategies have the characteristics of a “Taleb distribution”, after Nicholas Taleb, author of Fooled by Randomness. At its simplest, a Taleb distribution has a high probability of a modest gain and a low probability of huge losses in any period. Second, the systems of reward fail to align the interests of managers with those of investors. As a result, the former have an incentive to exploit such distributions for their own benefit. Professors Foster and Young argue that it is extremely hard to resolve these difficulties. It is particularly difficult to know whether a manager is skilful rather than lucky. In their telling example, the chances are more than 10 per cent that the fund will run for 20 years without being exposed. In other words, even after 20 years the outside investor cannot be confident that the results were not being generated by luck or a scam. It is also tricky to align the interests of managers with those of investors. Obvious possibilities include rewarding managers on the basis of final returns, forcing them to hold a sizeable equity stake or levying penalties for underperformance. None of these solutions solves the problem of distinguishing luck from skill. The first also encourages managers to take sizeable risks when they are close to the return at which payouts begin. Managers can evade the effects of the second alternative by taking positions in derivatives, which may be hard to police. Finally, even under the apparently attractive final alternative it appears that any clawback contract harsh enough to keep unskilled managers away will also discourage skilled ones. It is obviously best not to pay the manager, as a manager, at all, but rather to invest alongside him, as at Berkshire Hathaway, Warren Buffett’s investment company. But we still have the challenge of knowing whether the manager is any good. We know this today of Mr Buffett. Fifty years ago, that would have been very hard to know. What we have then is a huge “lemons” problem: in this business it is really hard to distinguish talented managers from untalented ones. For this reason, the business is bound to attract the unscrupulous and unskilled, just as such people are attracted to dealing in used cars (which was the original example of a market in lemons). The lemons theorem states that such markets are likely to disappear. The same may happen to today’s hedge-fund industry. Now consider the financial sector as a whole: it is, again, hard either to distinguish skill from luck or to align the interests of management, staff, shareholders and the public. It is in the interests of insiders to game the system by exploiting the returns from higher probability events. This means that businesses will suddenly blow up when the low probability disaster occurs, as happened spectacularly at Northern Rock and Bear Stearns. Moreover, if these unfavourable events – stock market crashes, mortgage failures, liquidity freezes – come in stampeding herds (because so many managers copy one another), they will say: “Nobody could have expected this, but, now that it has happened to all of us the government must come to the rescue.” The more one believes this is how an unregulated financial system operates, the more worried one has to become. Rescue from this crisis may be on the way, but what about next time and the time after next?

Gaps between the prices of US government bonds and futures may seem small, but the money to be made from exploiting them, by those in the know, is enormous. The sheer size of the numbers involved is eye-watering. One former Wall Street banker said some investors, using a strategy known as relative value Treasuries trading, regularly made profits in excess of $100m a year from it before the financial crisis. Hedge fund managers in New York gossiped about a trader who is said to have made half a billion dollars out of the trick in 2016. This may sound unrealistic, but court papers filed by Jonathan Hoffman, who moved to Barclays after the collapse of Lehman Brothers, suggest it is not so far-fetched. Mr Hoffman sued his former employer for failure to pay an $83m bonus — though he did not ultimately recover the full sum. Mr Hoffman claimed he made $540m in profits for the bank in 2008 and $225m in 2007. The strategy relies on price discrepancies between similar securities in the Treasuries market, and has been thrust into the limelight this week after being criticised by the Bank for International Settlements for exacerbating the stress in the repo market in September. That blow-up sent overnight borrowing costs, where investors borrow cash in return for high-quality collateral such as US Treasuries, sharply higher, and market participants are still trying to figure out exactly what went wrong. The story has all the hallmarks of financial villainy: greedy hedge funds creating turmoil in the market. But others say that it is a sideshow for the much larger issue of declining bank reserves and rising Treasury issuance that has constrained lending activity. The basic premise of relative value trading is to find differences in price between two assets that are nearly identical. One common way to conduct this trade is to buy Treasuries and sell related derivatives contracts like interest rate futures. In theory this trade carries no economic risk — you are buying one thing and selling another, very similar thing. However, because they are not exactly the same, there is a small price difference between them, extracted by the trader. The problem is that the price difference is very small, and therefore not very profitable. To make it worthwhile, traders take the Treasury security they just bought and exchange it in the repo market for more cash. They can then use this fresh cash to bulk up the size of their trade, repeating the process over and over, increasing leverage and juicing returns. Few of these traders still work at major Wall Street banks. A clampdown on risk-taking pushed them to find new homes at hedge funds. Michael Gelband, Mr Hoffman’s boss at Lehman, moved to Millennium Management. John Bonello, widely considered to be one of the biggest players in the market, joined later. Mr Gelband later left Millennium and set up his own fund called ExodusPoint in 2017, reuniting with Mr Hoffman who joined him as a trader. Other big funds, like Capula or Alphadyne, can also trace their professional lineage back to the big banks. Millennium, ExodusPoint, Alphadyne and Capula all declined to comment for this piece. Recommended Tail RiskJoe Rennison Expect more repo turmoil, says analyst who predicted September spike It is these hedge funds’ rampant demand for cash that the BIS says exacerbated a sharp move higher in overnight borrowing costs in the repo market. Trades structured on the premise of borrowing large sums of cash from banks were undermined as those funds dried up, it suggested. Few deny the episode was painful for funds caught off-guard, but given the speed at which rates returned to normal, it is not thought to have been catastrophic. Capula, for example, ended the month of September with flat returns, according to one person with direct knowledge of the fund’s performance. For the stability of the repo market, bankers, analysts and fund managers say the bigger issue is the amount of US government debt in the market, which is draining cash out of banks’ reserve accounts that might otherwise have flowed through into the repo market. The Federal Reserve reduced the size of its balance sheet from $4.5tn to $3.75tn between October 2017 and July of this year. At the same time, the US government’s deficit continues to increase, requiring sales of even more Treasuries. With many investors searching for yield in riskier corners of the stock and bond markets, banks have been left to buy up the debt in the absence of the Fed. If hedge funds had not stepped in as a buyer, bankers say that they would be pressured to hold even more Treasuries on their balance sheets — meaning even fewer reserves in the financial system and potentially worse turmoil in the repo market. “The original sin in the US Treasury market right now is not . . . people trying to profit from dislocations, it is excess supply from the US government,” said one repo banker. “If the US government hadn’t issued a lot of debt in 2019, we wouldn’t be having this conversation . . . The reality is that if the hedge funds didn’t buy Treasuries it would be a lot worse.”

Few people anticipated the eruption in overnight borrowing costs that spilled through the US financial system in September. One of those who did, clearly articulated in research reports a month earlier, was Zoltan Pozsar at Credit Suisse. In Mr Pozsar’s latest research, published this week, he predicts that further stress at the end of the year will prompt the Federal Reserve to restart full-scale quantitative easing, rather than just buying short-dated Treasury bills, as it is now. September’s chaos in the overnight repo market, where investors borrow cash in exchange for high-quality collateral like Treasuries, led the New York Fed — Mr Pozsar’s former employer — to pump billions of dollars into the financial system in an attempt to ease the cash crunch. The scale of the Fed’s response underscores the crucial role the repo market plays in moving cash around the financial system and financing purchases of US government debt. It has arguably become the primary transmission mechanism for the US central bank’s monetary policy. The Fed’s attempt to ease the strain in this market has not been enough, Mr Pozsar contends. He says that banks’ excess reserves — cash held at the Fed that can be recycled into the repo market — are still too low, despite the Fed’s attempt to increase them. On top of this, banks are running up against regulatory thresholds that are pushing them to reduce the size of their balance sheets. These could constrain lending in the repo market as banks attempt to avoid higher capital charges. All this points to significantly higher borrowing costs at the end of the year. The Fed’s primary tool for getting cash into the repo market is to lend to its primary dealers, predominantly big banks, in the hope that they then lend this money among a broader set of market participants. But just because banks have circulated this cash since September is no guarantee that they will do so at the end of the year, says Mr Pozsar. In addition to adding cash through repo operations with primary dealers, the Fed has been buying short-dated Treasury bills. The problem is banks do not hold many Treasury bills, but they do hold a lot of other Treasuries. Mr Pozsar says that the Fed’s next step will be to unleash the full capabilities of QE and buy US government bonds of all maturities. This would, in effect, reverse the central bank’s attempts to shrink its balance sheet, which drained cash out of financial markets from late 2017. “People have been blaming banks for not lending or blaming hedge funds,” Mr Pozsar told the Financial Times. “My bigger picture point is that we tapered the balance sheet too much, too fast. The Fed needs to undo that.”

Hedge funds have enjoyed a bumper payday after a resounding victory for Boris Johnson’s Conservative Party touched off a big rally in UK assets. The FTSE 100, which has lagged behind other global benchmarks in part because of concerns over Brexit, jumped 1.1 per cent on Friday immediately after Mr Johnson’s win. The index surged a further 2.3 per cent on Monday, in its biggest one-day gain of the year. While sterling has given back some ground after one of its biggest rallies on Thursday evening, the UK currency is still up 1.3 per cent over the past two trading days, on a par with the Korean won as the world’s best performing. Among the fund managers celebrating is Davide Serra, founder of London-based investment firm Algebris, which manages $13bn in assets. He described Friday as “a very good day” and said his funds reaped a gain of around £60m over Friday and Monday, following the rise in UK stocks and credit. He has been buying UK assets this year and said the country had risen to be one of his top geographic exposures. “The real extreme risk of [Labour leader Jeremy] Corbyn” has now gone, he said, citing policies from the opposition party leader such as the enforced nationalisation of certain private sector assets. Mr Serra added that his funds’ positioning had not been driven by a bet on the outcome of the poll but rather because he believed the assets he backed were “rock solid”. Most hedge funds will not report performance numbers to investors for a matter of days or even weeks. However, among those set to profit is London-based Marshall Wace, which manages $44bn in assets. The fund has built a net long position on UK stock prices, according to a person familiar with its strategy. The firm’s co-founder and chairman, Paul Marshall, wrote in the Financial Times last week that Mr Johnson’s policies, combined with “new-found political stability,” would make the UK “a very attractive investment destination”. He noted that the currency and the stock market had been trading at “20-30 year . . . lows”, on a relative or absolute basis. Also among those who could profit is Crispin Odey, founder of Odey Asset Management. This year Mr Odey had been betting that both sterling and UK stocks would fall, according to a letter to investors seen by the FT. But in recent months Mr Odey has cut both positions. As of the end of last month he was betting on rises in UK stocks, while running only a minimal bet against sterling, according to an investor letter this month. Mr Odey, who donated to Mr Johnson’s leadership campaign this year, has previously said the Conservative leader would be “a great prime minister” in a “new Jerusalem” after Brexit. However, Mr Odey has also said his own political views are “entirely different” from the way he trades his funds. Many hedge funds are likely to do well because they have been building positions in UK stocks, according to brokers. According to a client note from Morgan Stanley seen by the FT, funds have been increasing their bets on FTSE 100 stocks rising in recent months. Such bets are now running at close to their highest level in around eight years. “We expect to see sterling and [the] FTSE 100 rise together” through the first quarter of next year, wrote Morgan Stanley analysts in the note.