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08 December 2023

The bind of 'The Great Unwind'

By Paul Murphy


About a year ago a couple of investment analysts at Dresdner Kleinwort published a hefty piece of research looking at the importance of hedge funds to the investment banking industry.

Stefan-Michael Staimann and Susanne Knips were ostensibly examining the medium to longer term profitability of the likes of UBS, Deutsche and other leading European banks. But along the way, the analytical duo made some sweeping statements about the hedge fund industry in general – warning that “The Great Unwind” was coming and that it was going to hurt.

This was controversial stuff at the time – not least because the analysts were, by implication, opening questioning on the very business model used by their own employers, Dresdner Kleinwort. In subsequent research, Mr Staimann and Ms Knips toned down their prose and reined back some of their projections – which is a shame, because there is evidence now that the Great Unwind they warned about is actually beginning to happen, albeit for reasons slightly different to the scenario these analysts set out in February 2007.

The DK pair identified a number of uncomfortable truths.

Given the high transaction costs racked up by hedge funds (running at 4 per cent of the $1.3 trillion under management) along with high salaries and performance fees (accounting for another 4-5 per cent) meant that in order to keep their investors happy (with a return of, say, 10 per cent) the average hedge fund had to generate an annual return of close to 20 per cent.

Yet the strategies employed to produce these returns are not necessarily sustainable. Mr Staimann and Ms Knips argued that a clear majority of hedge funds could be thought of as leveraged sellers of deep-out-of-the-money put options. They employ long-short strategies – removing market risk with what are essentially spread or arbitrage bets with a relatively low return. To boost returns they use extensive leverage. These spread arbitrage positions did produce what looked like low-risk returns most of the time – but, once in a blue moon, what are effectively options written by the hedge funds were bound to get called.

What’s more, while hedge fund strategies across the industry may have looked diversified, there was actually a high degree of correlation, since many funds are effectively running leveraged bets on stable or tightening risk premia. Any widening of risk premia would force large-scale liquidations of positions, with margin calls by the banks and redemptions by investors reinforcing the process.

The analysts declared at the time: “We believe that the great unwind is inevitable, but impossible to time. It looks like the process of building up leveraged spread bets has already run quite far. Risk premia in many markets are very low, making it increasingly difficult to find spread bets for new money. Market volatility has been driven to record lows (remember: selling a put is like shorting volatility). The process may not have much more room to run and may start to be more sensitive to factors that could threaten its delicate balance (such as a deterioration of corporate credit risk).

“The virtuous cycle on the slow way up (the supply and demand from building spread bets leads to tightening spreads, which in turn raises confidence to build new positions) turns into a vicious cycle on the fast way down.”

Now look what has happened recently in Western financial markets. After months of chaos, where central bankers have failed to alleviate liquidity problems amongst the banks, and where the risk premia attached to just about all assets has continued to ratchet higher, some big hedge funds are starting to crack – being forced into disorderly liquidations in the process. Witness Carlyle Capital, Peloton, Highland Capital, Tisbury Capital, Focus Capital and probably plenty more over the coming weeks.

How worried should we be by all this? Painful as it all may look in the short term, my instinct is to say “Not at all.” Western financial markets are now in their eighth month of crisis. A cathartic event is needed to clear the air – and a string of big hedge fund collapses could be that event. The financial system somehow needs to set a new base line and rebuild from there.

Will the hedge industry be irreparably damaged? Not a chance of it. The hedge industry draws on sophisticated trading strategies – a sophistication that is not going to be “unlearned.” The industry will simply evolve, becoming more sophisticated in the process.

And, in any case, there are still hedge funds making a bundle from this crisis. Just look at Lahde Capital. Shorting sub-prime produced a return of 870 per cent for the top fund managed by Andrew Lahde last year.
Paul Murphy is Associate Editor of the Financial Times.