In spite of the obvious analogies between the current frigid weather in the US Northeast, we at AllAboutAlpha.com have long been intrigued by how one puts a dollar figure on a frozen asset.

Indeed, one thing no one has seemingly ever figured out (and conveyed publicly, to our knowledge) is what the assets frozen by Lehman Brothers’ 2008 bankruptcy might have been worth had hedge funds and others actually been able to take them out and sell them.

In a global market where everyone was tripping over each other for the exits, what would securities that on the books might have been worth something before September 15, 2008 were, at the time of Lehman’s failing, basically worth nothing? More…

A lot of commentators – particularly in the mass media – have blamed hedge funds for the financial crisis.  But unfortunately, their rhetoric is often very knee-jerk and lacks the necessary detail to actually make their arguments convincing.   So in our yearning for a cogent argument against hedge funds, we were very excited to read this column yesterday by Kiplinger.com contributing columnist Steven Goldberg called “Ban Hedge Funds?”

But alas, Goldberg’s arguments don’t wash.  In fact, they’re so stained with apparent indignation toward hedge funds that we felt a need to document the fallacies and half-truths raised in the piece.  As players in financial markets, hedge funds – like mutual funds, banks, pension funds, and individual investors – are all accomplices to the calamities.  But the cause?  I guess that you can find research to prove anything.  But here’s our take on the arguments raised by Goldberg…

Claim: “Much of the demand for what Warren Buffett years ago termed ‘financial weapons of mass destruction’ came from hedge funds.” More…

When you were a kid did you ever get in trouble for merely hanging around with the wrong kids?  Did your friends ever drop a water balloon on your teacher and run away, leaving you behind to suffer detention for a week and an enduring reputation as “that little brat”?  Well, according to a paper to be published in the forthcoming edition of the Entrepreneurial Business Law Journal, that’s pretty much what happened to the CDS market over the past year.

The paper (“Guilty by Association?  Regulating Credit Default Swaps“) is written by AllAboutAlpha.com contributor Houman Shadab, a Senior Research Fellow at George Mason University (see AAA guest post).  Shadab applies his unique ability to simplify complex issues affecting the intersection of law and finance to this article.  He argues that CDS’s aren’t nearly as evil as they are made out to be.   Instead, they just happened to be hanging around with CDOs when CDO’s got in trouble.

Writes Shadab:

“…failing to distinguish between CDS and the actual mortgage-related debt securities, entities, and practices at the root of the financial crisis may hold CDS guilty by association…Unmanageable losses from CDS exposures were largely symptomatic of underlying deficiencies in mortgage-related structured finance and do not primarily reflect fundamental weaknesses in the risk management and infrastructure of the CDS market.”

He goes on argue that the growth in CDS’s on CDO’s was an “effect”, not a “cause” of the growth of the CDO market.  As a result, he recommends against knee-jerk regulation of the CDS market.  A US bill aimed at creating a central clearinghouse of CDS’s would, he writes, “undermine bilateral risk management” (a central tenant of the current OTC market).

“Born of Regulatory Sin”

…Not that CDS’s are angels or anything.  Shadab acknowledges that they were…

“…in a sense born in regulatory sin:  They were first used by commercial banks in the last 1990’s in part to decrease the amount of capital that regulation required banks to hold in reserves.”

Not surprisingly then, regulation ignored CDS’s in their time of need at AIG:

“Regulation did not properly limit, and regulators did not diligently supervise, AIGFP’s (AIG Financial Products) use of CDS. In particular, mis-priced asset-backed security risk seems to have been a root cause of the regulatory oversight failure. OTS regulators stated that they failed to adequately recognize and act upon the risk posed by AIGFP’s multi-sector CDS on CDOs primarily because they failed to appreciate the risk of the CDOs’ underlying mortgage-related collateral.”

AIG

In fact, much of Shadab’s paper focuses on the role of CDS’s in the near-demise of AIG.  According to AIG’s financials and various related documents, the firm’s financial products group was exposed to a notional value of $527 billion in debt through CDS’s (about 1% of the $58 trillion CDS notional exposure at the time):

“AIG failed in September 2008 because of a liquidity crisis. AIG was not able to meet its short-term obligations with the cash the company had available or was able to raise. These obligations stemmed primarily from being required to post approximately $39.7 billion pursuant to the CDS that AIGFP had written on multi-sector CDOs, so named because the CDOs contained different types of residential and commercial mortgage-backed securities as collateral. In part because AIG was unable to meet the collateral obligations, the U.S. Department of the Treasury and the Federal Reserve Bank of New York arranged loans and other types of federal assistance for AIG.”

Without absolving AIG from any of its responsibilities to use CDS’s appropriately, Shadab recommends that new regulations should prevent over-concentration of CDS risk in individual companies.

AIG Not a “Hedge Fund”

In March Ben Bernanke famously called AIG a “hedge fund”.  But as Shadab points out, AIG did not in fact, use CDS’s in the same way a hedge fund might have:

“This description does not seem apt, however, because AIGFP’s CDS activities were fundamentally different from how hedge funds typically utilize CDS.  AIGFP utilized CDS as a type of long-term fixed income asset or insurance product not subject to reserve requirements, principal funding, daily marking, or oversight by regulators. This in part explains why AIGFP executives viewed CDS as “free money” compared to their traditional business lines and used flawed mathematical models focused only on the long term cost of default and not the short-term variables of collateral risk and contract pricing. Hedge funds, in contrast to AIGFP, typically view CDS as instruments with both long-term and short-term risk and actively trade CDS as part of a strategy involving other credit instruments.”

Hedge fund or not, this in-depth, yet easy-to-follow telling of an infamous story in financial history makes for great reading.

Last fall, we questioned the commonly-held assumption that hedge fund redemptions played a major and direct role in the market downturn.  As market participants, hedge funds surely played a role.  But were they a catalyst?  As we pointed out, commentators have recently begun to revere a set of mystical dates (“D-Days”) based on the Hedgistanian redemption calendar.  Worshipers of these date contend that 45 days before the end of each quarter, the hedge fund spirits begun to dump their holdings.

Geoffrey Rogow of the WSJ’s Marketbeat blog examines this calendar obsession today as this coming Sunday marks the beginning of the 45 day countdown to the end of Q1.  He writes that:

“Some believe it was no accident the market hit its low point on Nov. 20, just more than 40 days before the end of the fourth quarter, when redemption requests would have been at their peak.”

Until we see academic evidence of this, our jury remains out.  According to HFR, overall 2008 redemptions were about $175b in the second half of last year – most of it in Q4.  That’s about 10% of the hedge fund industry’s January 2008 AUM.  While many hedge fund were revealed to be long-bias in Q4, a large proportion of funds still contained significant short positions (particularly market neutral funds and short bias funds).  So the effect of redemptions is mitigated by the upward price pressure caused by closing out those short positions.

In addition, while hedge funds are certainly higher velocity traders than traditional hedge funds, their AUM is puny compared to other investors.  AIMA’s “Roadmap to hedge funds” published in the fall, compared hedge fund AUM to pensions, insurance companies and other institutional investors: More…

We spend a lot of timing combing through the hedge fund and institutional media.  Quite often we find that the headlines on hedge fund stories are somewhat disconnected from the content of the article.  Mainstream journalists we know tell us that it’s not uncommon for headline writers to take creative license in an effort to jazz-up an otherwise pedestrian story.  Well, the headline writers were out in force this week.  We have read several stories whose headlines either misrepresent the facts in the article, mischaracterize the key players, or miss the point of the story entirely.  That’s a shame when the journalists have obviously worked hard crafting their stories.

Trimming hedges: In uncharacteristic fashion, The Economist overstates the challenges facing hedge funds and their role in recent market events in this review of an academic study we covered before Christmas.  Says the newspaper, hedge funds’  “…economic power has reduced even more…” recently.  But with overall assets down less than global equity indexes on a percentage basis, it’s hard to see how hedge fund “economic power” is any different today it was a few short years ago (even accounting for recent lower leverage levels).  At that point, magazines like the Economist warned about the excessive influence of hedge funds.  (Also…a 5-point deduction for using the “hedge-trimming” analogy yet again.)

European hedgers bleed assets: Investment News headline writers miss the mark somewhat with this report of how European funds of funds (not “hedgers” themselves) are forecast by Reuters to lose 75% of their assets.  While single hedge fund managers will surely be impacted, this is a (debatable) conclusion about the fund of funds model, not about hedge funds themselves. More…

Ponzi. Not since the term “hedge fund” was first used has there been such disagreement over financial terminology.  Suddenly, Ponzi schemes are all over the news.  Forbes’ noted last week in a story called “Everything is Coming up Ponzi” that “authorities are bagging mini-Madoffs left and right.“  Last Thursday, the US government took action against two more “Ponzi schemes” (neither starting with an “M”).  One was allegedly perpetrated by an 82 year old man against elderly members of the Catholic community.   And the other was allegedly orchestrated by a Philadelphia man who convinced investors to part ways with $50 million.

So are these two new Ponzi schemes really Ponzi schemes or is the SEC frantically trying to make up for previous lapses to show that they are back on top of things?

“Little Ponzi’s”

If Time Magazine’s Ari Officer is right then finding Ponzi schemes will be like shooting fish in a barrel for the SEC.  In fact, Officer writes that there is actually a Ponzi scheme in every hedge fund.  The reason is that like all investment funds, hedge funds routinely have a lot of unrealized gains and losses.  The extra challenge faced by hedge funds, however, is that the unrealized gains and losses are locked up in less liquid assets.

As a result, writes Officer, hedge funds sometimes need to rely on new investments to pay out old investors.  After all, why would a fund liquidate a position – particularly one that the manager feels is trading at a discount – when the fund already has a whack of new cash from subscriptions.

In fact, a fund doesn’t even have to do anything wrong to fall under Officer’s broad definition of Ponzi scheme:

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With the surfeit of cataclysmic hedge fund news being reported daily, it’s easy to lose perspective.  However, Barton Biggs injected some balance into the hedge fund discussion with a piece in Fortune last week.  Wrote Biggs:

“In every bear market I have seen, the doomsayers concoct a statistical argument that the glory days for stocks are over, because a flood of selling by brutalized investors is inevitable, and the buyers have no money. This case always seems most compelling close to the end of the declines and is always marked by a wave of media pronouncements.”

Today, we take Biggs’ lead and deliver a newsreel made up entirely of “good news” stories that seem to suggest hedge funds may just survive the financial crisis after all…

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Apparently, the stigma associated with closing redemption gates is quickly disappearing.  As Thomson reports,

Blocking investors’ exits, even if only briefly, was once a highly unusual move that often signaled a hedge fund was on the verge of collapse, managers and investors acknowledged…That is changing now as ever-more managers and investors engage in a tug of war over who can receive money right now.”

Wealth Bulletin cites 6 hedge fund managers that have suspended redemptions and several that have offered “sweeteners” for investors to stick around.  The list of new gates includes: Centaurus Capital, Polygon Investment Partners (old news), Gottex Fund Management, Wermuth Asset Management, Auriel, and Atlantis Investment Management.  According to the publication, favorable fee sweeteners have been offered in exchange for locking-in capital at: RAB Capital, Ramius Capital, BlueBay Asset Management and Henderson Global Investors.

The Times reports on an interesting twist.  RAB Capital, says the paper, is offering a form of IOU to investors that promises to pay them out as soon as the firm can sell the requisite securities (not, we assume, at some later redemption date).

The ground isn’t the only thing being frozen in Minnesota this fall.  Investment News reports that Deephaven, the $1.6 billion multi-strategy fund, froze redemptions when 30% of investors asked for their money back.  Apparently the fund was up 16% per year for 10+ years, then hit the skids with a -25% YTD by the end of October. More…

With so much breaking news to digest recently, it’s difficult to find the time to look down the road at what’s coming next for the alternative investment industry.  Critics of hedge funds often evoke images of the fictional Lake Wobegon where the children “are all above average”.  But the current market crisis may finally help us all move beyond this tired metaphor.

To begin with, the FT peered into the crystal ball last week to predict how the asset management industry would look when the dust settles.

“…the credit crisis could accelerate the change already blowing through the asset management industry and reconfigure it so that risk management becomes centre stage and hedge funds become part of a bigger absolute return sector.”

And in the mind of at least one industry expert, the future is all about alpha (and beta)…

“‘The credit crisis is causing an inflection point,’ says Suzanne Duncan, the financial markets industry lead for the [IBM] Institute [for Business value].  ‘Asset management chief executives think the industry is going to change significantly “and they don’t know how they should react’. Ms Duncan thinks this is good news rather than the reverse.”

“She expects three types of players to emerge as the dust settles: in the jargon of the industry, there will be firms focusing on alpha, beta and advice.

“Investment banks will become beta, or market return, providers. Their leverage levels will drop from the 30 times common today to perhaps 10 times – the same as commercial banks. That will cut in half their return on earnings, leading to an exodus of “talent” to the buy side.

“That will lead to growth in the alpha, or skill-based, industry. ‘We will see alpha providers getting much bigger,’ says Ms Duncan.”

Despite this endorsement for alpha-centric investing, the FT remains somewhat skeptical…

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It’s becoming difficult to tell whether the mass hysteria surrounding hedge funds this month is driven by reality or schadenfreude. There is little doubt that some high profile hedge funds will experience some redemptions this week. But today alone, we saw the hedge fund industry being described as a “horror show”, a “hellfire” and a “bloodbath” that is “heading for the rocks“. We heard about “investors pounding on the doors to get out”. We were warned by experts that there is “smoke billowing from Greenwich” and that the “suffering will be profound”.

While this is great copy, it simplifies the hedge fund industry in the same way that talk of hedge fund managers all buying yachts was de rigueur only a few years ago.  Less widely reported was that hundreds of hedge funds closed up shop every year during those Halcyon days.  And less widely reported today is that fact that many funds are thriving in today’s environment (and not just the mega-short funds like Paulson & Co.). The high dispersion of hedge funds illustrates their attractive quality – idiosyncractic risk. In aggregate, hedge funds are down around 10% YTD. But recent reports suggest that over half of hedge funds were reporting positive YTD returns right up to the end of August.

It’s becoming a knee-jerk reaction to warn of the perils of hedge fund leverage.   Some estimates suggest the $2 trillion hedge fund industry had amassed up to $600 billion in cash by the end of September in preparation, some hypothesize, for quarter-end redemptions. This dramatic de-leveraging has also been picked up by various measures of leverage (see related posts).

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Nearly 10 years ago, two Tremont executives and a new media manager for a Thomson Financial publication had an idea – a website that would “be the first independent Internet community and e-commerce platform which will be the catalyst for reinventing the way the industry communicates and transacts its business“.  They called it “HedgeWorld” and it quickly became a leading Internet brand in the burgeoning hedge fund industry. 

Said the firm’s December 8, 1998 press release:

“Hedgeworld.com features a wealth of tools and information products and services that benefit investors, managers and service providers. For example, an individual investor in Switzerland can receive customized news from major online sources for all the hedge funds included in their actual or model portfolios in HedgeWorld. Or, an investment manager based in London can broadcast an alert to a pre-qualified audience of financial institutions in Asia. In addition, a prime broker in New York, at the direction of its hedge fund manager, can send specific portfolio information to selected investors in a secure environment. Members of the media can use HedgeWorld to distribute or research stories. For regulators, HedgeWorld can enable greater transparency and disclosure among community members. Timely and accurate online information is enhanced by easy-to-use site design, objective and in-depth hedge fund industry research, accurate performance data and secure e-commerce capabilities.”

It was an audacious goal, but one that attracted a lot of users, sponsors and eventually acquirers.

However, after changing hands a number of times, HedgeWorld’s new owners (somewhat ironically, Thomson Reuters) laid off the majority of staff this weekend, ending a storied history and releasing a team of excellent financial journalists into the waiting arms of the hedge fund community (see Friday’s posting).  Reports suggest the brand may live on (as MAR Hedge did after it met its maker in 2006), but there seems to be little question that this marks an end to the franchise as an independent entity.

In deference to the grande dame of hedge fund websites, we have assembled a gallery of HedgeWorld screen shots from throughout the firm’s history (thanks to archive.org).  For online publishers like us, it’s interesting to see how each site reflects the prevailing web design conventions of the day.  But even if you don’t care about these kinds of things, you will find this walk down memory lane may at least remind you of better days for the industry…  (late breaking addendum: for a little extra walking down memory lane, check out HedgeWorld’s own tribute to its departing crew here) 

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After two years at the helm of the eponymously named Insana Capital, former CNBC anchor Ron Insana has scuppered the ship – bailing out for calmer waters at SAC Capital.  Also this week, it was revealed that a reporter and columnist for the Wall Street Journal was lured from the fifth estate by Plainfield Asset Management and Dane Hamilton of Reuters was hired by Carl Icahn to write his blog postings for him.  This, after MarketWatch’s Herb Greenberg bailed to start his own research firm in July.

It’s almost as if financial journalists don’t get paid enough or something.

All of a sudden, hedge funds seem to want to hire people who have huge networks, are intelligent and have a great understanding of the hedge fund and financial service industry.  But the trend, if it is one, began some time ago.  This is just the latest chapter in an ongoing dance between hedge funds and media people.

About a year ago, I was having lunch with a business journalist friend who was being courted by a major hedge fund company to join them to help with marketing.  At around that time, someone emailed me a job description for an opening at a hedge fund that specifically included “journalism” as a prerequisite.

Even today, you see more and more job listings popping up with the words “investigative” and “journalism” in them.  Here’s one I picked off such a job board earlier today:

“…Bachelor degree with a stellar academic performance required, master degree could be a plus.  Must have strong investigative skills, a background in journalism could be a plus…”

The question is: are asset managers suddenly realizing how to exploit the skills of (underpaid) financial journalists, or are the journalists trying to escape before they are taken to the firing line along with thousands of their colleagues in the media industry?

Who knows?  But financial journalists and hedge fund managers may have a lot more in common than first meets the eye.  As Tim Price, himself an (excellent) part-time financial columnist said way back in 2006:

“They live in a high-octane world. What they do is risky. They’re grotesquely overpaid, they have few scruples, and their influence on the markets is out of all proportion to their true size. They’re fast, extremely short-termist and utterly unregulated. Yes, they’re journalists writing about hedge funds.”

The list of stories below was lifted from the most recent edition of our “Alpha Mail” monthly email update.  Each month, we try to highlight stories that illustrate two sides of a hedge fund or alpha-centric issue.  This month’s set of links clearly illustrate the wide divergence of angles on the current state of the hedge fund industry. (note: you’ll need a free registration to view some of these.)

Battered funds cling to hope of recovery (Financial News): “Hedge funds are struggling to shake off their worst quarter since records began…”

Hedge fund investors want out sooner, not later (Reuters): “Worried about hedge funds’ low returns and high fees, more well-heeled investors are now talking about getting out of these loosely regulated portfolios than getting into them…”

HNWIs cool on allocation to hedge funds (Hedge Funds Review): “Allocation to hedge funds from high net worth individuals (HNWIs) slipped to 9% in 2007 from 10% in 2006…”

Tough Markets Alter HF Managers’ Practices (HedgeWorld): “Last year’s turbulent market environment prompted hedge fund managers around the world to lower leverage ratios and move a significant share of their assets into cash…”

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Amongst public relations professionals, there is an axiom that goes something like this: In the absence of the complete story, journalists are forced to create their own conclusions. 

Many companies have learned that starving the news media of the facts they demand often backfires.  In such a situation, journalists a) have no choice but to attempt to fill in the gaps with conjecture and b) often do so totally unchallenged.  So “filling in the gaps” is actually a very rational response when you think about it. 

A column on Monday by one of Canada’s most respected commentators makes this point in spades.  In a piece entitled “Hedge Funds: the credit crunch’s enigma“, Globe & Mail columnist Eric Reguly makes a series of remarks about hedge funds that even he suggests is based on little, if any, hard facts.

Clearly miffed about another drive-by smearing, the Canadian Chapter of AIMA (the Alternative Investment Management Association) followed its parent organization’s lead this week by speaking out – this time in a letter to Reguly obtained by AllAboutAlpha.com yesterday. 

As you may recall, AIMA’s London headquarters issued a rare rebuke of hedge fund media coverage last month in the form of a press release quoting the organization’s Chief Executive (see related posting, read press release).  Taken together, these responses suggest AIMA is taking a more active stance on educating the media and the public at large about alternative investments.  And that’s a good thing.

Here’s what Reguly said about hedge funds on Monday:

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