Aren't hedge funds supposed to hedge? In 2011,
as managers swerved in sync with the stock market's wild
swings, one might have wondered if hedging is a lost art. Maybe
it is, as managers in many strategies - from equities and
market neutral to event-driven and multistrategy - grappled
with the thorny issue in a year of heightened volatility.
The performance of hedge funds since 2008 illustrates the
problem: They failed to capture much of the upside in 2009 and
then did worse than the markets on the downside last year.
That's not the way it's supposed to work. It's okay for
hedge funds to gain less than the market when it's rising -
after all, they are hedging - but when the market goes down,
they should lose less. Theoretically, the alpha masters should
be able to prosper during times of wildly fluctuating
If these were the hedge fund rules, they have been broken
now. While the S&P 500 was flat for the year, the median AR
Composite Index fell 0.47 percent. Last year, when managers
tried to hedge, it was often too little, too late: They reduced
exposure, then the markets reversed and they missed the run-up,
creating what's been dubbed the whipsaw effect. In 2009, in
contrast, the S&P 500 gained 23.5 percent, and the median
gain for the AR Composite was 14.83 percent.
Even star managers have acknowledged the difficulty of
hedging these days. At his annual investor meeting in late 2010
and in Las Vegas last spring, John Paulson warned that he would
not be using certain hedging techniques because they had become
too expensive. Paulson increased his hedges later in the year,
but it was too late: Paulson's Advantage fund was down 36
percent in 2011, while his Advantage Plus sank 51 percent.
Paulson's losses were among the heftiest, but other
event-driven managers were also hit hard. Typically long, some
resort to shorting indexes to hedge even though they don't have
overall market risk. But event-driven managers tend to invest
in riskier names, and these fall the most when the market goes
through one of its gut-wrenching nosedives. That might be one
reason the AR Event-Driven Index was down more than 5 percent
for the year - the worst performance of any AR index by some
100 basis points.
Some managers short indexes instead of individual stock
names because of the unlimited downside potential of short
positions. Shorting individual stocks has also gotten more
costly, in part because prime brokers are having trouble
locating the stocks to borrow. It seems that since the fracas
following the Lehman Brothers bankruptcy, pension funds and
insurance companies have become wary of lending their
Options, whose prices are a function of time, interest rates
and market volatility, are another way to hedge individual
names; their cost is limited to the premium. But despite low
interest rates last year, puts were extraordinarily expensive
because of market volatility.
Those who have figured out how to short individual names
prospered in 2011. One such manager is Mason Capital
Management, which gained about 5 percent, in part by shorting
credit spreads, property developers and solar energy companies,
according to investors.
Elliott Management was another savvy hedger last year,
netting 4.2 percent in its onshore fund, much of it due to
gains on hedging. Through the third quarter, Elliott reported
that its portfolio volatility protection earned the fund 3.9
percent gross of fees and expenses. Some of the hedges employed
were sovereign credit protection strategies, single-name
high-yield shorts, gold call options and some rates trades.
A subset of event driven, risk arbitrage was also tough to
hedge last year, and the much-anticipated flurry of deals just
didn't happen. When News Corp.'s bid for BSkyB fell through
last summer in the wake of the investigation into the
Murdochian method of news gathering - illegal phone hacking -
the arbitrageurs who bet on it lost a bundle. Among them were
Perry Capital and Taconic Capital Advisors. Perry's offshore
fund fell 7.57 percent for the year, while Taconic's offshore
event-driven fund ended down 2.7 percent.
Perhaps just as important, funds like Taconic also paid up
for expensive tail hedges, designed to kick in if the market
falls substantially in any single day. In a year when
Armageddon seemed right around the corner, given the shaky
status of the euro, the downgrade of U.S. debt, the Arab Spring
and the Occupy movement, these hedges gained currency - and
became quite pricey. Employing them inside a regular hedge fund
ate into returns last year.
It's a little bit of the damned if you do, damned if you
don't. But hedge funds will have to do better this year to keep
their reputations, if not their assets, intact. AR