Relative-Value Funds: Down But Not Out
By Nina Mehta
After soaring through most of the 1990s, relative-value hedge funds last fall fell to earth. Hedge funds in general got the blame, but relative-value funds took most of the heat. Its known that they use leverage, after all, the way car tires use pressurized air to revolve.
In the wake of the leverage scare caused by Long-Term Capital Managements near-collapse, some market participants were eager to see last fall as the premature demise of relative-value strategies. Now, half a year later, its clear that the fears were overstated. Although relative-value funds experienced some rapid deleveraging last fall, the trading strategies werent thrown over or abdicated. Instead, credit terms for hedge fund financing were tightened, and leveraged funds were required to provide more disclosure about their rules and risk controls.
|There is a superior recognition of leverage and how the funds would handle a liquidity crisis.
Relative-value is a tag covering a number of strategies, but what they all share is the assumption that a departure from fair value or equilibriumin terms of a given relationship between instrumentswill eventually return to its historical or statistical norm. Since markets already tend toward efficiency, however, and since more capital hung on a mispricing will reduce the spread, the profit made on temporary dislocations is generally small. The funds must therefore lever up their profits with financing.
Classic relative-value or market-neutral funds last year faced more significant redemptions and losses than other hedge funds, logging in lower returns at the end of 1998 than investors had come to expect. Yet redemptions were lower than predicted. Combined losses and redemptions, which some thought would be in the neighborhood of 50 percent to 75 percent, turned out in October to be substantially lower for almost all funds.
Since then, a number of changes have swept over the relative-value world. The biggest is that funds have been exposed to more restrictive credit policies by the broker-dealer community. Many of the changes correspond to terms and conditions in the credit support annex of the International Swaps and Derivatives Association master agreement, notes Bradley Ziff, director for strategy and business development for financial institutions at Arthur Andersen. These include more detailed language concerning change of thresholds, the requirement that funds that normally did not post initial margin now post margin, higher levels of haircuts for some products and a broader understanding of the type of risk-mitigation efforts funds utilize to manage their exposures. Overall, the changes may have been more technical than transformative, but they were meaningful to the broker-dealer community, says Ziff.
Relative-value funds have also been required to disclose more about their strategies and exposures. Most of these changes occurred in the late fall of 1998 and have carried over into 1999. Broker-dealers, funds-of-funds and individual investors all demanded new clarifications of strategies; a more frequent posting of net-asset-value figures; portfolio disclosures that sometimes included cash and trading positions; and more information about redemption status. As a consequence of the additional information, people have a far better appreciation of the types of risks the funds are undertaking, notes Ziff. There is a superior recognition of both the types and amount of leverage and, in a growing number of cases, how the funds would handle a liquidity crisis and its effect on their own portfolios.
Although there has been fiery talk about the need to rein in hedge fund trading hubris, a regulatory mandate is not considered a strong bet. Investors need to protect themselves, and lenders as wellmaybe by not overlooking precautionary measures that should be taken in order to get business, points out Joseph Nicholas, chairman of Hedge Fund Research, a Chicago-based consultancy, and author of the recently published Investing in Hedge Funds. But thats a business decision.
For investors, the return on relative-value strategies will have to be higher than it has been in the past, says Irenee May, vice president at JP Morgan, since the risk associated with these strategies has increased.
For lenders, the recent bout of regulatory interest and the heightened importance of monitoring relationships has added to the cost of doing business. Transparency doesnt come without a cost, says May. You need resources to keep track of that and monitors to understand it. Moreover, documentation and the relationships those documents support will have to be an integral part of the changes that occur. This could involve, for instance, looking at how the terms and conditions for swaps might conflict with those required for repos, and reexamining policies concerning the matching of collateral positions at the end of each trading day.
Although Wall Street firms are expected to continue dedicating large amounts of capital to hedge fund sales channels and intermediation, their controls are liable to be tighter. At the same time, speculates Chris Tormey, a managing director at Bear Stearns, there is likely to be a retrenchment and return to traditional specializations in hedge fund strategies.
Relative-value started out as a strategy employed by dealers that had unrestricted two-way flow and access to information, before moving into the hedge fund arena. In the mid-1980s, as a result of a lack of volatility in the bond market, hedge funds reached into areas they were less familiar with, he says.
Tormey expects hedge funds now to move back toward the basicswhat the careers and trading records of notable fund managers were built on. An example of what the industry might see, he says, comes from III Finance in Florida. A couple of years ago, when III saw what it perceived as an opportunity in the Russian market, it decided not to take on new exposures in one of its two existing funds but to create a third fund. It was that fund that suffered the Russian bond market defaultbut it was the one designed to take on Russian risk. Were going to see more of that kind of thing, predicts Tormey. With regard to new strategies and asset classes, if a manager sees an opportunity but its quite different from what hes established in funds he already runs, we may get the formation of a new pool of capital, thus isolating the new risk from the original capital base.
Another change awaiting the hedge fund community at large could involve redemption provisions. Unlike other pooled capital, hedge funds usually allow investors to make withdrawals only on a monthly, quarterly or annual basis, and many funds impose a six-month or one-year lockup period in which new investors cannot redeem their capital. Its therefore possible to see last years hedge fund turbulence as a case of bad timing. Its unfortunate that what happened [with LTCM] occurred so late in the game, in August, says Leon Metzger, president of Paloma Partners Co. Many hedge funds require investors to give written notice by September 30 if they want to make a year-end withdrawal, he adds, so when problems occurred in late August and early September, hedge funds had to start harvesting cash to prepare for year-end redemptions. To do this in an orderly manner, they exited their positions in an illiquid market. And when liquidity returned to the market, they couldnt go back into the trades, because they needed that cash for year-end. Its telling, he notes, that LTCM is up nearly 12 percent in the first quarter of this year.
Yet another issue bearing down on the hedge fund community is where new money will come from. One problem highlighted last fall was that hedge fund financing was sometimes provided by institutions that did not have a large-enough, stable capital base that could stomach the volatility. When that happens, says one market participant, you then have a problem that becomes magnified as margin calls are made.
|For investors, the return on relative-value strategies will have to be higher than it has been in the past.
In the future, investment banks may have to look more rigorously into investing in hedge funds as owners or partners rather than as lenders. If that occurs, say some, prospects for hedge fund financing will be less problematic. Alternately, other sources of guaranteed-leverage funding could be sought by fund managerssuch as longer-term capital through collateralized bond obligations, an option thats feasible but more expensive than straight financing. Some industry participants also expect more money in the future to come from the funds partners themselves.
In the meantime, its worth remembering, as Hedge Fund Researchs Nicholas puts it, that financial disasters generally result in improvements to the system.
Recommendations for Collateral Programs
By Robert Hunter
The financial markets have been as volatile during the past two years as any time this decade. Without collateral agreements, of course, the losses could have been truly disastrous. Collateral serves as the bulwark of countless over-the-counter transactions, keeping counterparties from twisting in the wind during periods of market turmoil.
In mid-April, the International Swaps and Derivatives Association released the definitive study of dealer collateral programs to date. While much of the news is good, the industrys guardian angel has offered a whopping 22 suggestions for improvement. It comes at a good timecollateral agreements have been increasing at an amazing clip during the last five years. As of year-end 1998, ISDA estimates, some $175 billion to $200 billion was put aside as collateral for OTC deals.
ISDA surveyed a dozen dealers in January to determine the extent of their collateralization programs. Some had existed since the early 1990s, it found, but fully half have come into existence since 1994. The report notes that there has been a significant expansion in the use of collateral since then, with the firms surveyed averaging 523 collateral agreements in place by year-end 1998. The actual range varied from 25 to 1,400, and firms with programs in place longer tended to have more agreements in place.
The distribution of collateral agreements among counterparties is telling: Slightly less than half of all agreements are in place with industry professionals, including banks and broker-dealers, while 20 percent are with hedge funds, 20 percent with corporate clients, 8 percent with central banks and 7 percent with other counterparties, including individual investors.
|Some funds appetite for credit generally far exceeds the level of unsecured credit available.
For each group, the report notes, there are reasons why collateral use has increased so profoundly in recent years. Industry professionals, besides trying to reduce overall credit risk exposure, have discovered that the more firms that use collateral, the greater the volume of business that can be executed under a given credit line. This powerful combinationreduced credit and capital costs, coupled with increased credit capacityhas greatly increased transaction capacity, the report notes.
Collateral agreements between broker-dealers and hedge funds are often bilateral. For dealers, collateralization is sound risk management. While the size, credit rating and performance record of some funds may enable them to obtain a degree of unsecured credit, reads the report, their appetite for credit generally far exceeds the level of unsecured credit available and, for the vast majority of funds, delivering collateral may be a prerequisite to obtaining sufficient credit. As for hedge funds themselves, receiving collateral against positions that are in-the-money allows them to monetize the unrealized gain while keeping the exposure to the position to reap more upside potential.
End-users of derivatives are using collateral agreements more and more as well. Whereas dealers have asked lower-credit-quality counterparties to enter collateral agreements for years, higher-credit-quality corporates have recently begun asking dealers for collateral. Derivative end-users are typically seeking to hedge an underlying risk of their business, the report says, but, in doing so, do not wish to add another type of undesired riskthe risk that their derivative provider may default. For central banks and supranational entities (such as the World Bank), which are often quite active in derivatives markets, and often have relatively long-dated positions, bilateral agreements are clearly mutually beneficial.
In terms of the types of assets used as collateral, any will do, but some are far more popular than others. Cash intuitively seems like the perfect instrument, but many avoid it because of the questions it raiseshow the cash should be invested, who bears the investment risk, what the acceptable rates of return are and so on. The vast majority of collateral agreements use U.S. Treasuries and other high-quality, highly liquid securities such as Fannie Mae, Freddie Mac and Ginnie Mae paper. But some two-thirds of the firms ISDA surveyed reported that they also use securities issued by other governments, ranging from G-5 to, in some cases, G-10. Only one out of five firms surveyed uses other securities such as equities, corporate bonds or non-G-10 sovereign debt.
Perhaps the most eye-opening finding of the survey is the $200 billion collateral figure. The report notes, however, that the estimate doesnt account for rehypothecation of collateralwherein firms recycle incoming collateral to meet outgoing collateral requirements. Still, such numbers are massive for off-balance-sheet items, and ISDA notes that the Financial Accounting Standards Board is considering a reinterpretation of FAS 125 to require that where the right to hypothecate exists, pledged collateral would appear on the balance sheet of the holder as a receivable from the counterparty. ISDA says this could devastate liquidity ratios and capital calculations, and its implementation would force firms to think twice about hypothecating.
The results for collateralization in 1998 are encouraging. Of the 11 firms that provided data, the report notes, one said that not a single collateralization counterparty was closed out (meaning that market conditions caused the entity to default on a collateral delivery, fail to meet a payment obligation, formally declare insolvency or decide to cut-and-run from positions and close up shop). Seven firms closed out between one and nine counterparties, and three closed out more than 10. Good figures all, given the level of market turmoil last year.
Enhanced Yields With Minimal Risk
A new structure tries to make a high-return strategy more palatable.
If 1998 taught the financial world anything, it was that volatile markets are highly correlated on the downside. The relentless march of globalization has made Harry Markowitzs rules of diversification increasingly important to institutional investorsand increasingly difficult to apply.
Ferrell Capital Management thinks it has created a derivatives-based investment vehicle that addresses this problem. The companys Concert product, disseminated by a Bermuda-based special-purpose vehicle called Concert Series I, consists of two note issues: a $120 million senior floating-rate note, and a $30 million income note, both of which carry five-year maturities.
The products are tailor-made for investors hungry either for investment-grade debt or noncorrelated, nonrisky assets. The senior note is an A1+ rated structured note, credit-enhanced by a major money-center bank, which pays a coupon of three-month Libor plus 40 basis points. Return-hungry investors will be more attracted to the unrated income note. Ferrell will invest the income generated from both the senior tranche and the income tranche in order to lever up the returns of the income notes.
How? Ferrell divvies the proceeds to different asset managers, who use long/short strategies in various G-10 fixed-income and currency products. Ferrell monitors the managers performance daily and rebalances the portfolio to stay within a target volatility of 5 percent, in a process it calls dynamic risk allocation. The company has been using a 5 percent target volatility for the last 30 months to considerable successit registered a 5.3 percent year-end figure in 1998 amid a wildly spastic global marketplace.
|The product works because the strategies are well diversified through the risk-allocation process and enjoy constant monitoring and control.
The best news for investors: Ferrell is projecting returns on the income notes to be anywhere from 20 percent to 40 percent. It also predicts a high Sharpe ratiothe measure of a portfolios risk-adjusted returnof more than 1.0, because the long/short strategies focus on G-10 bonds and currencies, and do not inject credit risk into the portfolio. The risk profile were putting into Concerts assets is roughly equivalent to an eight- or 10-year U.S. Treasury bond, says Ralph Boynton, marketing director at Ferrell. Concerts overall correlation is expected to be anywhere from -0.2 to +0.2.
The product works because the strategies are so well diversified through the risk-allocation process and the constant monitoring and control, says William Ferrell, president of the firm. Its difficult to make investments in equities or bonds and find low correlations. We can find diversification among the long/short strategies we use, because theyre entirely different from each other, dealing in different markets with different timing and objectives. Essentially, were pushing the benefits of the Markowitz theory to the limit.
Beware of Asian Capital Controls
By Robert Hunter
Since the Asian meltdown of 199798, international economic leaders have bandied about more than a dozen strategies to prevent relapses around the world. Most of the remedies include various capital controls designed to prevent the volatile money flows and massive speculative attacks at the heart of the economic collapses. Some forward-looking derivatives pros are keeping a close eye on the situation, and for good reasonthe imposition of capital controls can throw sand into the gears of even well-established derivatives markets.
Malaysia is the most famous recent example of an emerging-market country imposing controls, and its not alone. By the end of this year, says Steve Hanke, professor of applied economics at The Johns Hopkins University, there will be some new global financial architecture that will likely include capital controls. Theyre all interventionist, central-planner-type mechanisms to try to keep the money cool. The basic idea: to build an economic version of a semi-permeable membrane around a diseased country, through which money can flow in but not out. At the most basic level, a capital control is any type of restriction on capital mobility, including restrictions on foreign investment into a country and on money flowing out of a country. More broadly, capital controls can include rules preventing the liquidation of major capital investments (such as factories), as well as price controls, interest rate ceilings and other market interventions.
|Capital controls build a wall around the local derivatives market, and foreign players are supposed to be kept out of it.
All of these things could spell trouble for derivatives players both within and outside emerging-market countries. The most obvious problem: capital controls reduce opportunities for trading and risk management by limiting market access. In the context of derivatives, says Christopher Culp, director of risk management services at CP Risk Management and adjunct associate professor of finance at the University of Chicago, capital controls build a wall around the local derivatives market, and foreign players are supposed to be kept out of it.
In addition, capital controls inject lethal doses of legal and credit risk into existing and future transactions. A 10-year swap struck by, say, an American bank and a Malaysian counterparty would be virtually destroyed by a capital control imposed by the Indonesian government in the fifth year of the contract. While the American bank may have been in the money at maturity, collecting the money would be a different story.
As if legal risk werent enough, capital controls would also ravage pricing and valuation models, driving a wedge between the underlying market and the derivatives market. The currency market serves as a good example. If a country imposes controls on currency convertibility, says Culp, then any currency swaps or currency forwards negotiated outside the country are going to have trouble perfectly obeying the principle of no-arbitrage, because there wont be any capacity for anyone to engage in the synthetic transactions that would replicate the forward contract.
Of course, successful derivatives pros typically view such bugaboos not as problems but as opportunities, and capital controls could have positive impacts on the business as well. Murky pricing, for instance, would actually benefit some dealers. To the extent that pricing is difficult using the traditional textbook models, says Culp, that means that more end-users who are looking to hedge will be willing to compensate dealers for solving complicated pricing and valuation problems.
Another way capital controls could benefit the derivatives business is by introducing more volatility into the market. Capital controls in emerging markets tend to create volatility rather than suppress it, says Culp, and volatility is always a good thing for the derivatives markets. Controls would also increase the demand for asset protection through vehicles such as credit derivativesassuming, of course, that counterparties are willing to take on the legal and credit risk.
Perhaps the biggest boon capital controls could offer the derivatives business is the opportunity for financial innovation. When capital controls are imposed on national markets, offshore markets can pop up quickly, offering cash-settled hedging alternatives to the national physical markets. The most immediate example is the eurodollar market. When the United States imposed interest rate restrictions in the early 1960s, a parallel market developed in London; now, London is the premier market for dollar-denominated certificates of deposit. Over and over again, says Culp, we see examples in which countries that impose capital controls end up stimulating financial innovation, creating new markets and opportunities for people to participate in derivatives.
As for the risk management implications of capital controls, there is one simple rule: Take the costs of capital controls into consideration when evaluating investment and trading opportunities. For a company deciding to build a factory in a country with capital controls, says Culp, the benefits of the factory need to exceed the cost of the transaction. All too regularly, people exclude some type of estimate of the political costs associated with capital controls. The swaps market, he says, is the best example of this. When external Bank A does a swap with Company B in a country where capital controls exist, the swap shouldnt be at market for Bank A the day its executed, because bank A is bearing the risk that if its in the money on the swap it may never actually be able to get the money. The solution? It should demand a premium from Company B to do business in the first place.
Even in the biggest emerging-market scrap heaps, it seems, one mans junk can be another mans gold.
Last Year At A Glance
CIBC reads everything so you dont have to.
Many derivatives pros have, at one time or another, started keeping files of press clippings to track the important developments in the business. But even the most ambitious clippers quickly find that taking the time to keep up with the reams of reportage on a regular basis is nearly impossible. Luckily for them, Charles Smithson, managing director at CIBC World Markets, for years has managed a staff of eager clippers at CIBCs School of Financial Products who do just that.
The latest product of their efforts is Managing Financial Risk: 1999 Yearbook, published this spring by CIBC in softcover and, for the first time, on the School of Financial Products web site. As usual, the yearbook serves as a compendium of the previous years highlightsand lowlightsin the business.
The yearbook immediately stakes out its territory with a review of the financial markets in 1998. The key themes, it argues, were high volatilities, high correlations and high credit spreadsmostly the result of the roiling emerging markets. The yearbook summarizes the developments in East Asia and Eastern Europe, paying particular attention to the problems in Indonesia, Malaysia and Russia. Of particular use to the more insular of derivatives practitioners is the description of Indonesias flirtations with instituting a currency board. And the box titled What Is A Currency Board? offers a succinct definition of the term, the pros and cons, and some examples in a mere five paragraphsa lively alternative to a financial encyclopedia entry.
The yearbooks finest achievement may be its description of the JP MorganSouth Korea debacle, in which Morgans in-the-money contracts with Boram Bank were legally challenged by a third party, SK Securities. Since last December, reporting on the dispute has dried up completely, leaving the CIBC account as the most current and thorough to date. The yearbook takes on Long-Term Capital Management with similar verve, sprinkling boxed reactions from the troubled hedge fund throughout its narrative and addressing the regulatory firestorm the episode created.
The book does a workmanlike job of summarizing all of the major market surveys on derivatives done in recent years as well. Among the findings: Despite the well-publicized scrutiny and debate on new accounting rules, the majority of U.S. firms are keeping their risk management strategies intact
German firms appear more relaxed about using derivatives and some of the statistics on their risk governance imply stricter policies and procedures as the underlying reason. In Asia, the surveys suggest less use of derivatives by industrial firms. Before the turmoil began with the devaluation of the Thai baht, many firms had reduced or abandoned their use of derivatives altogether. Corporates in this region continue to be hesitant to manage their exposures using derivatives.
The School of Financial Products web site, at www.schoolfp.cibc.com, houses other useful tidbits as well. In addition to the 1997 and 1998 yearbooks, calculators covering forwards, basic options, second-generation options, volatility and risk management techniques are included, and it promises to have on-line tutorials and a derivatives game up and running shortly.
PwC Brings OpVaR to Market
By Nina Mehta
No one likes to be reminded of disasters and financial losses. But if youre in charge of operational risk management, losses are your daily fare. If you know where your exposures lie and can measure them, you can allocate capital against them and figure out how to control them better. PricewaterhouseCoopers believes it can help. Last month it released OpVaR, a risk quantification methodology supported by a loss database that helps institutions rein in operational risks.
PwC takes a broad view of operational risk, defining it as those risks that fall outside market and credit risk. Since some operational lossessuch as failures in transaction processing, IT problems, rogue trading, fires and project mismanagementhave a direct, negative profit-and-loss impact, they can be tracked. OpVaRs loss database includes public information about losses from both financial and nonfinancial institutions, coupling external losses with the internal loss history of the clients PwC works with. The database, which took a year to develop, includes 4,000 publicly reported losses, plus additional internal ones. So far, says the consulting giant, a couple of financial services companies are using OpVaR.
But there are other risks, such as strategic, reputation and business-interruption risks, concedes Michael Haubenstock, a partner in PwCs global risk management solutions practice, that are more difficult to quantify. The firm therefore uses a scenario approach with clients to figure out, for instance, what might happen if market share in a particular business line eroded, or how a major catastrophe might affect the loyalty of a banks customers. If you run through enough scenarios like thatwhat the potential impacts would beand you model the P&L and balance sheet against the sensitivity of revenues and margins, you get a range of answers, says Haubenstock. And if you have a range of answers, you can quantify the resulting risks.
For a loss database to be useful, however, the integrity of data and their relevance to other institutions must be ensured. Clients always face the hurdle of thinking, Here I am trying to use these data and Ive got a loss event from somebody twice as big as I am, says Haubenstock. In considering various scaling factorsnumber of employees, asset size, revenues, expensesPwC found that the highest statistical correlation between losses in different companies occurred against revenue. So we concluded that by scaling information by revenue, we could use data from multiple companies to apply to any one institution, he notes.
Managers in financial institutions have always been quick to improve risk controls when they got bad audit scores or when weaknesses surfaced, but theyve never been able to quantify the potential impact of shoring up controls. And without that, says Haubenstock, its difficult to motivate improvements to be made or evaluate the costs and benefits of alternative solutions. OpVaR links improvements of controls in line organizations with performance measures and compensation to senior management. There are other operational risk systems available to institutions, but those are essentially black-box software solutions, says Haubenstock. Since OpVaR was created as an open methodology, clients can customize the modeling as they wish, focusing on different variables for different risks, choosing which data to use when and from which types of companies.
Another application for OpVaR is enabling institutions to evaluate their insurance programs. OpVaR puts the same analytical tools that insurance companies use to quote their premiums in the hands of the institutions to make them more informed buyers, explains Haubenstock. The analytics include direct risk-by-risk inputs for insurance coverage, which allows clients to figure out whether or not a particular insurance policy makes sense given the frequency and severity of an event. If, for instance, the cost of an investment banks premium for a rogue-trading loss of $50 million is not offset by the reduction in capital achieved by buying an insurance policy, the bank can restructure its coverage to kick in at a higher level.
As operational risk management becomes more disciplined, predicts Haubenstock, information about operational losses in databases will be fuller and more precise across more detailed risk lines. Measurement will also become more sophisticated. Right now, he acknowledges, its difficult to evaluate data from other institutions to reflect the quality of their controlsand there is as yet no public rating of institutions control environments. But PwC has a hypothesis: One reason institutions are highly rated is because they have a low volatility of earnings, which may suggest they have infrequent large, unexpected losses. If this hypothesis holds true after the testing phase, adds Haubenstock, credit ratings could serve as a proxy for the quality of controlsand would be incorporated into OpVaR as an additional scaling factor.
Moodys Surveys CDOs
In the first quarter of 1999, collateralized debt obligations were written at a staggering pace, says Moodys Investors Services in a recent report. Moodys says it rated 34 transactions with a total notional value of $21.5 billion, up from 22 transactions and $13.3 billion in the first quarter of 1998. (Moodys notes that since there is a seasonal pattern in CDO issuance, with far more activity in the second half of the year, year-to-year comparisons are the most valid.)
Among the new developments so far this year: an industry-wide campaign to re-securitize tranches of outstanding structured transactions, including asset-backed, commercial mortgage, residential, REIT and even CDO instruments. Moodys also notes that emerging-market CDO proposals are creeping back into the fold, as investor confidence strengthens in that area of the market. Synthetic structures are also taking off. Moving one step beyond the increasingly familiar credit default structures, the report announces, Moodys recently rated a transaction in which a German insurance firm reinsured itself against credit exposures by issuing notes with payoffs linked to the performance of an index of small European company defaults.
For a copy of the report, call 212-553-7941.
The market for collateralized debt obligations has grown dramatically in the last five years.
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