The hard truth about hedging

By Michelle Celarier

Wed Feb 1, 2012

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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 markets.

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 securities.

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

ISSN: 2151-1845 / CDC10004H