Even seasoned CDO managers like Solent Capital were calling the Bear Stearns announcement on 19 July, that two of its CDO funds had effectively collapsed, "an isolated incident". Datamonitor released a report in mid-July predicting growth in the market for UK sub-prime mortgages as more UK consumers experienced financial difficulties, but British lenders were not given much opportunity to deploy such loan products en masse before interbank liquidity dried up.
It is not fair to say that hedge fund firms were caught completely off-balance by the crisis. There had been concerns voiced about the US economy, the sub-prime sector, and the US housing situation in particular, for many months leading up to August. But it is the scale of the crisis, and the role of major investment banks - in turn the prime brokers to thousands of hedge funds - at the centre of this storm, that has created a host of problems which managers will be grappling with well into the New Year.
Hedge funds are not perfectly at the centre of the current market storm - that distinction lies with the banking sector, sub-prime lending and conduits. However the web of linkages between banks and hedge funds, the blurred distinctions between conduits, SIVs, and SIV-lites, the former sponsored and managed by banks, the latter sponsored by banks but managed by hedge funds, and the similarity of issues facing banks and hedge funds, particularly in relation to valuation and risk management, demonstrate how integral hedge funds have now become to the workings of the financial system.
Indeed, it is fair to say that the hedge fund industry has an influence in financial markets which is totally disproportionate to its $1.3 trillion of assets under management.
Whilst the current preoccupation may be with the role of hedge funds in relation to financial stability, there are other equally important issues of concern both to regulators and to other stakeholders.
While all administrators and prime brokers will attest to this, there is evidence that they are right. Many managers have gone far beyond the original boutique structure and the influx of investment (primarily from institutional investors), is tending towards the big names which follow standard international practices. According to a report published in July by KPMG on 'The State of the Investment Management Industry in Europe', the top 100 funds currently hold 65% of the assets. The emphasis now is on building a business, offering an infrastructure that works and attracting the so-called sticky money. The methods used to attract that investment mean that many managers have had to sharpen up their act.
Administrators and prime brokers are finding that they are the cornerstone of hedge fund business rather than mere 'service providers'. Regulators and investors are calling for more extensive reporting and those that can service the ever-increasing trade volumes are finding that their own assets under administration are also growing at a rapid pace.
Leading indicators are at high levels. This is true both for indicators related to consumers and those for producers. My impression, however, is that broadly speaking we do no longer see an acceleration in many of the indicators. Some of them, like the German Ifo-index for producer sentiment, have slightly fallen. This leads me to expect that the euro area business cycle is close to its peak or has just passed it.
The ECB kept its policy rate at 4% at its meeting at the beginning of July. The outlook is that growth will somewhat moderate from above trend this year to around trend in 2008. Inflation is projected to be slightly above 2% both this and next year.
Although past interest rate increases are starting to impact narrow money growth, the tightening process has not yet reduced broad money growth (M 3), which continues to grow at double digit figures, and overall credit growth. Liquidity remains very ample. Under these circumstances, the ECB will probably hike again in the third quarter of this year, bringing the policy rate at 4.25%.
Different from many other market observers, I do not a priori expect further ECB interest rate increases beyond 4.25%. Should the signals that euro area growth has peaked become stronger, the ECB may well go on hold at an interest rate of 4.25%. I would consider this rate to be slightly restrictive, but it has to be kept in mind that at the same time liquidity is very ample and lending conditions appear to be rather lax. The next move may then as likely be up or down.
Nursing heavy losses from the bursting of the tech equity bubble followed by a long period of unprecedentedly low interest rates (and tax breaks in the US) has encouraged the notoriously optimistic investor to seek out higher returns by taking on ever-greater degrees of risk; investing in ways that under more normal circumstances they would not even consider. They are probably unaware of the real risks involved - such as using high levels of leverage secured on over-inflated asset prices, or investing in higher-yielding emerging market assets.
What the future holds
Nobody in Washington DC's legal community, or in the US government, seem to have anticipated the furore that would be sparked off when Eller & Company, a Florida firm with two joint ventures with P&O, hired a semi-retired lobbyist to represent its objections to Capitol Hill. Once New York senator Chuck Schumer (D) had got on board, the story's profile was raised, provoking more questions in Congress, and ultimately led to the eventual sale of P&O's US operations to AIG for an undisclosed sum.
The important point here is the role played by CFIUS. The agency, which is tasked with ensuring that US companies that are of a nationally strategic character (including everything from software firms with government contracts to utilities) do not fall into the hands of hostile states, has been around since the closing days of the Reagan administration. During the Clinton years there was very little concern about foreign transactions in the US, and consequently CFIUS' role was somewhat overlooked in the euphoria that followed the end of the Cold War.
Since 2003, however, bids by companies from countries like China, France, Israel, and the UAE of course, have come under an enhanced degree of scrutiny. The Chinese National Oil Company's bid for Unocal was derailed in 2005, again by hostility to the deal in Congress.
Utilising both sets of products more fully can free up a manager to focus on their core role of determining and capturing investment opportunities, as they can reduce the time and resources required to execute some of the possibly non-core investment duties that hedge fund managers must often undertake. A key area for consideration is designing and executing an optimal strategy for managing cash.
In the last two weeks of the quarter, however, markets reversed and pushed higher as economic news, particularly from the labour market, surprised to the upside and concerns over US sub prime debt did not spread to the broad housing market. Over the quarter, the MSCI World Index gained 1.68% in LC.1
Hedge funds started the year well with all styles contributing positively. Only commodity managers struggled as crude oil prices declined sharply. The second half of the period proved a bit more difficult as equity hedged and managed futures had to cope with market reversals. However, by the end of March all styles except managed futures were in positive territory. Event driven was once again the best performing style as special situations and distressed managers weathered the choppy markets well. The HFRX Global Hedge Fund Index gained 1.57%.2
European managers outperformed US, Japan
After all, prime broking is one of the most important service provider slots that need to be filled when setting up a hedge fund, and it is hardly less important five years down the road. But in between, much can be achieved by the hedge fund which can manage its prime broker relationships effectively.
Although they are often lumped in with other institutional investors such as pension funds, endowments and foundations have a very different raison d'être, time horizon and hence investment objective. Key to understanding this is the concept of 'perpetuity' - not quite as difficult to grasp as infinity but still radically different from the effect even of the long-term horizon of an open defined benefit pension fund. Most endowments exist to provide income for institutions engaged in charitable activities. They may not have significant amounts of new money coming in and they have an obligation to future generations to preserve the spending power of the endowment. 'Intergenerational equity', to use the phrase coined by James Tobin, an economist at Yale, requires the institution to balance spending to meet the needs of the current generation with the need to make sure it can meet the needs of future generations by a policy of purchasing power preservation.
"The endowment is managed in perpetuity," says Nick Cavalla, recently appointed CIO of Cambridge University's Investment Board. "With that in mind, it can afford to take a very long-term view." For this reason, endowments can have a different attitude to risk from funds that need to align their assets with their liabilities over a mere matter of decades instead of perpetuity.