Janet Tavakoli’s letter to the Editor of Financial Times
Sir, The Financial Services Authority claims that hedge fund gearing has decreased (report, May 2) and the Federal Reserve Bank of New York suggests that there is no close correlation between hedge fund returns making the current situation less alarming than in the past (May 3). I believe it was Winston Churchill who said we must alert somnolent authority to novel dangers; but in this matter authority seems complacent, and the dangers are not novel.
The FSA produced numbers from a partial survey of hedge funds and discussed “average” leverage, thus highlighting the well known flaw of averages. If a swimming pool’s average depth is four feet, but the deep end of the pool is eight feet, non-swimmers are presented with unacceptable risk. The average would suggest non-swimmers can safely use the pool, but a drowning man finds out the hard way that the average doesn’t contain information descriptive of the risk.
The NY Fed uses data to examine volatility and correlations, both of which are not of much use in a crisis when correlations deviate from historical measures and even approach one. Indeed even today, one should consider that hedge fund returns are anything but independent. Hedge funds are often called “alternative” assets, but they have not created new asset classes. Hedge funds invest in the global markets along with other investors, albeit hedge funds may be more creative, more illiquid and may employ more leverage.
“Tavakoli’s law” states that if some hedge funds’ returns soar above market averages, then others must crash and burn. If one accepts that passive investors are indexed and reap average market returns, then active investors that reap extraordinary returns above the market average are offset by active investors who experience extraordinary losses in aggregate.
The current situation may indeed be different from that presented by Long Term Capital Management, but it may be even more alarming, not less alarming. Due to the use of structured products and derivatives, hedge funds can take on hidden leverage above and beyond that which can be explained by polling prime brokers. Furthermore, illiquid structured products will experience a classic collateral crash when hedge funds try to liquidate these assets to meet margin calls or collateral “cures”.
Since 2000, assets invested in hedge funds have more than tripled to around $1,500bn. While on average leverage may appear manageable, some hedge funds – Amaranth to cite a recent example – employ high degrees of leverage. A potential source of a “great unwind” arises from a trigger event affecting highly leveraged hedge funds, and another potential source is systemic risk that effects a larger cohort of hedge funds.
Many hedge funds are not highly leveraged, and they will weather the storm. But the explosion of hedge fund investments in illiquid assets combined with leverage currently pose a greater risk to the global financial markets than we experienced at the time of the LTCM debacle.
END OF LETTER