Voices: Hedge fund stars have to learn to take ‘no’ for an answer
With the coronavirus pandemic triggering wild price swings, hedge funds have got their dancing shoes on as they seek to make the most of volatile values and atone for their underperformance in recent years. While the temptation is for traders to load up on risk to boost profits and bonuses, strutting their stuff like drunken uncles at a particularly raucous wedding, a couple of recent blowups suggest that the risk managers charged with curbing those enthusiasms need to stand firm in setting and abiding by risk limits.
At Graham Capital Management, which oversees about $15 billion and specializes in global macro, a portfolio manager called Jeremy Wien lost a ton of money speculating on equity volatility, a measure of how much share prices move that in March quadrupled in the space of a few short weeks. The scale of the loss — $500 million gone from a $4 billion absolute return fund, according to my colleagues at Bloomberg News — suggests the U.S. firm didn’t step in quickly enough to stanch the bloodletting once the cracks in the position started to appear.
At H20 Asset Management, which ran into trouble last year after loading up on illiquid debt, a fund that lost 45% last month was downgraded by fund-rating firm Morningstar this week. H2O, which managed $34 billion at the end of last year, is run by Bruno Crastes and Vincent Chailley and backed by French bank Natixis. Morningstar singled out “bold macro bets” the pair are responsible for that it said “were not adequately reined in by formal risk controls” as its motivation for downgrading their Allegro fund to negative, the lowest level of its five-rung scale:
We think the balance of power at H20 is too strongly tilted in favor of portfolio managers. As an example, risk management cannot force portfolio managers to adjust exposures immediately if a risk limit has been breached because of market movements rather than active changes.
Risk managers at hedge funds need to be especially vigilant about the bets their traders are making to profit from current market dislocations or there's a danger they'll repeat the mistakes made by their banking peers that kindled the global financial crisis a decade ago, albeit on a shortened and potentially more explosive timescale.
Back then, the risk management officers at the world’s biggest investment banks had found themselves unable to say “no” to increasingly risky bets. That had disastrous consequences for the economy.
In an unsigned 2,000 word article published by the Economist in August 2008, an unidentified risk manager at what the weekly said was a large global bank admitted that the pursuit of profit had overridden prudence for several years:
Most of the time the business line would simply not take no for an answer, especially if the profits were big enough. This made it hard to discourage transactions. If a risk manager said no, he was immediately on a collision course with the business line. The risk thinking therefore leaned toward giving the benefit of the doubt to the risk-takers.
Banks — and their regulators — learned a hard lesson, and have curtailed many of their risk-seeking tendencies in the intervening years. The baton, though, has been passed on. So it’s vital that traders and portfolio managers in the investment community resist the temptation to chase returns by stepping outside of their risk boundaries. If they threaten to drift, risk officers should have the courage to restrain them — with the full and unconditional backing of their firm’s leaders and owners.
At least one hedge fund has long understood the need for gatekeepers of the firm’s risk budgets to have the status to be able to stand up to its traders. In 2006, Alan Howard made Aron Landy, his chief risk officer, a partner at Brevan Howard Asset Management as a way to ensure he had sufficient clout to go head to head when disputes arose. Landy must have done a good job; he was promoted to chief executive officer in October when Howard stepped back from his management role to focus on trading. Meantime, Howard’s main $3.3 billion Master Fund is enjoying its best year since it started in 2003, and was recently up by more than 20% this year.
Why should we care if a hedge fund chasing riches goes boom? Because, as Bank of England Chief Economist Andy Haldane said in a 2014 speech on the broader asset management industry, the danger of a fire sale of assets increases the possibility that “asset prices would be driven south, possibly to well below their long-term or fundamental value.”
In short, a widespread market crash triggered by indiscriminate asset-dumping by failing hedge funds would affect all of our investments, be that in pension funds or other savings vehicles.
“As long as the music is playing, you've got to get up and dance,” Charles Prince, who was then CEO of Citigroup, told the Financial Times in July 2007, four months before mounting losses and writedowns led to his departure from the disco. Hedge funds should be boogying hard — but with half an eye on the door, and always, but always, accompanied by a chaperone in the shape of a respected risk officer with the power to turn down the volume.