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An Overview of Hedge Funds and Structured Products: Issues in Leverage and Risk Adrian Blundell-Wignall With their high share of trading turnover, hedge funds play a critical role in providing liquidity for mis-priced assets, particularly when large volumes are traded in thin markets – thereby reducing volatility. This activity is particularly important, given the rapid growth in volume of new-generation structured products issued by investment banks. Hedge fund leverage estimated via an induction technique suggests a leverage ratio that must be above 3 (versus total AUM of USD 1.4 trillion). Gearing is required to boost returns where low risk and low return styles are implemented. Investment banks are well capitalised against hedge fund exposure. “Structured products” are one of the fastest growing areas in the financial services industry, and may already be over half of the notional size of the hedge fund industry (AUM plus leverage). These products, constructed by investment banks, are extremely complex using synthetic option replication techniques, and offering a variety of guarantees in returns. They are sold to retail, private banking and institutional clients. Hedge funds help reduce volatility risk for investment banks in supplying these products. Structured products are passive in nature (unlike hedge fund active styles), focusing on providing returns for different risk profiles of clients. These products have not been tested when major anomalies in volatility arise. They are highly exposed to downward price gaps in the „risky‟ assets used in their construction. Considering the potential for such a crisis scenario, two major policy conclusions emerge: The importance of (1) stress testing of investment banks‟ balance sheets; and, (2) given the large retail market segment, consumer education and protection. 37 ISSN 0378-651X © OECD 2007 An Overview of Hedge Funds and Structured Products: Issues in Leverage and Risk Adrian Blundell-Wignall* Executive summary *  The size of the hedge fund sector, using IOSCO sources and results from responses to an OECD Questionnaire on Hedge Funds, is around USD 1.4 trillion in assets under management (AUM). While this does not seem that large compared to total global AUM, the hedge fund share of trading turnover (augmented by leverage and investment style) is much greater than its share of global AUM.  On the issue of volatility, this paper shows that hedge funds play a critical role in providing liquidity for mis-priced assets – arbitrage opportunities – particularly when large volumes are traded in thin markets. This is a volatility reducing activity. This activity is particularly important, given the rapid growth in volume on newgeneration structured products issued by investment banks.  Hedge fund return performance, costs and style data can be combined to back out an implied number for global hedge fund leverage (in the absence of any hard data). The leverage ratio has to be well above 3 to come even close to consistency with the performance return numbers – leverage of over USD 5 trillion is implied.  This leverage does not imply undue risk. This is because gearing is Adrian Blundell-Wignall is Deputy Director in the OECD Directorate for Financial and Enterprise Affairs. The opinions expressed and arguments employed herein do not necessarily reflect the official views of the Organisation or of the governments of its member countries. 39 ISSN 0378-651X © OECD 2007 Financial Market Trends, N°92, Vol. 2007/1 required to boost returns on AUM for investors in hedge fund activities which, by their very nature, are low risk – because hedge funds to a large extent engage in market-neutral arbitrage activities that do not depend on the direction of the market.  Investment banks have strong capital adequacy, in particular with respect to their hedge credit fund exposures – some estimates of which are provided below.  Ironically, the fastest growing area of new financial products that utilise highly-complex derivative products exclusively lies mostly within the regulated sector. This is the market for “structured products” that are produced by investment banks and sold to retail, private bank and institutional clients. The strong volume growth in this area, particularly in Europe and Australasia, creates ex-ante derivative pricing pressure, and hedge funds frequently take the other side of the trades (reducing ex-post volatility).  The size of this market is very roughly estimated to be around USD 3.8 trillion, already over half of the notional size of the hedge fund industry (AUM plus leverage), and growing quickly in the last two years.  Structured products are passive in nature (unlike hedge fund active styles), and focus on providing returns (for different risk profiles of clients) with some element of capital guarantee. Constant proportion portfolio insurance (CPPI) is one of the popular newgeneration techniques. These products have not been tested when major anomalies in volatility arise. They are highly exposed to downward price gaps in the „risky‟ assets used in their construction.  The potential for a crisis scenario in the event of such anomalies in volatility, with multiple investment banks having to close positions (due to „knock-on‟ effects) is considered. Hedge fund and other counterparty‟s ability to meet calls in this situation would affect the size of the balance sheet risk for investment banks.  This raises two main policy issues. (1) The balance sheet risks to investment banks offering guaranteed products: stress testing for worst case scenarios and ensuring capital adequacy for them is important to reduce concerns about financial stability; and (2) given the large retail market segment, consumer education and protection. 40 ISSN 0378-651X © OECD 2007 An Overview of Hedge Funds and Structured Products I. What is a hedge fund? Hedge Funds have grown quickly over the past ten years, and are important part of the financial landscape. They are difficult to define as entities, because the line between what hedge funds do that other institutions do not is blurred – proprietary traders in investment banks, private equity funds, and fund managers all use extensive leverage and derivatives to trade markets or to shift risks. Lightly-regulated active investment style using derivatives The definition of a hedge fund used here is as follows: lightly-regulated managers of private capital that use an active investment approach to play arbitrage opportunities that arise when mis-pricing of financial instruments emerge. Extensive use of leverage and derivatives is a common feature of hedge funds. The main differences between a hedge fund and a private equity fund are: (a) the private equity fund looks to use leverage to buy companies to obtain full management control for purposes of changing its structure operations, whereas a hedge fund trades assets without looking for full control; (b) the hedge fund covers a multitude of styles, only one small part of which might involve buying shares to force management to make value enhancing changes (activist); and (c) hedge funds often (but not always) have a shorter investment horizon than private equity firms. They play a key role in providing liquidity II. Overall, hedge funds fill a broad role in providing liquidity in markets where pricing anomalies have occurred, often due to lack of breadth. In the main this is a volatility reducing activity that is an essential part of the efficient working of financial markets and financial stability. Hedge fund industry size: AUM versus turnover Size of USD 1.4 trillion AUM At the start of 2007, estimates suggest that hedge funds have over USD 1.4 trillion assets under management (considerably less than the USD 18 trillion in mutual funds; see Table 1). Some high-end estimates have it higher at closer to USD 2 trillion. The bulk of hedge fund activity is in the United States, followed by the United Kingdom and EU (ex UK), with Australasia next. 41 ISSN 0378-651X © OECD 2007 Financial Market Trends, N°92, Vol. 2007/1 Table 1. Hedge funds’ assets under management (AUM) Country Mid 2006 Estimates $bn USA 870 UK 320 EU 118.4 Australia 47 Non-Japan Asia 34.05 Switzerland 23.1 Canada 11 Japan 7 TOTAL 1430.55 Source: IOSCO; and OECD Questionnaire on Hedge Funds. Augmented by leverage Of course the „fire-power‟ of hedge funds is greatly augmented beyond this by leverage, though the amount of this is uncertain due to lack of reporting and the difficulty of assessing the implicit gearing of derivatives. Table 2. Shares of hedge fund trading in the US market Shares of Hedge Fund Trading in US Markets % 30 60 33 45 47 33 25 Cash equities Credit Derivatives (plain vanilla) Credit Derivatives (structured) Emerging Mkt Bonds Distressed debt Leveraged loan trading High Yield bond trading Source: Greenwich Associates, as reported in The Financial Times. And have a large impact on market turnover Leverage, when combined with a rapid and focused trading style, allows hedge funds to have a much bigger impact on market turnover than the AUM figures would suggest. In Table 2 data from Greenwich Associates suggests that hedge funds account for between 30% and 60% of market turnover, depending on the financial instrument concerned. This of course is very large indeed, and illustrates why understanding financial market behaviour today without 42 ISSN 0378-651X © OECD 2007 An Overview of Hedge Funds and Structured Products including explicit analysis of hedge funds is quite impossible. Two concerns often raised with respect to hedge funds are: (a) that they create volatility in markets due to their large role in turnover, and (b) that the leverage they undertake may raise financial stability issues, where defaults with counterparties occur – an issue given some credence by the late 1990s failure of LTCM, that required a major private bank-led work out to resolve. III. Hedge funds reduce volatility Volatility-reducing role The analysis in this paper suggests that hedge funds play a very positive role in financial markets by providing liquidity to thin markets where mis-priced financial instruments are to be found. This type of activity reduces volatility rather than increasing it. Particularly given the growth of structured products Indeed with the rapid growth of structured products in recent years, particularly in Europe and Asia, hedge funds have been quite critical in containing the volatility that might otherwise have arisen. Structured products are largely driven by investment banks, and have resulted in the proliferation of new and highly-complex derivative products (discussed below). Figure 1 shows the VIX index of market volatility, the junk bond versus AAA spread and the TED spread (the offshore Eurodollar 3-month rate versus the 3-month Treasury). Volatility has fallen, and spreads have narrowed. Hedge funds are put sellers in the carry trade In large part, spread narrowing in the past few years has been a process that has been driven by hedge fund or „carry‟ trades. These carry trades are usually implemented with derivatives. A spread emerges where risk premia in two financial instruments differ. These are taken advantage of by selling puts. These pay the seller a premium in income (positive „carry‟) and work as long as the spreads do not blow out as a consequence of some credit event. The buyers of puts (the other side of the trade), have negative carry (they pay a premium to the seller) and so continually lose money as markets rally and spreads narrow. Buyers rely for profit on an 43 ISSN 0378-651X © OECD 2007 Financial Market Trends, N°92, Vol. 2007/1 adverse credit event to occur to put them „in the money‟. The longer this does not happen the greater is the incentive of buyers of puts to stop further losses by quitting the trade. As this occurs the spreads have to narrow further (because buyers of puts need to be induced by further price action). In the absence of exogenous risk events, volatility continues to fall and spreads narrow. Structured products are natural buyers of puts Passive buyers of puts, including investment banks buying for capital guarantee purposes in structured products, benefit from spread narrowing in pricing their products for retail, private banking and institutional clients – encouraging the growth of this market. Figure 1. Falling volatility narrowing spreads Market volatility, corporate spreads and the TED Spread 60 % % VIX Corp Sprd(RHS) TED Sprd(RHS) 9 8 50 1987 40 7 Tech Bust S&L/LBO Crises Asia/LTCM 6 5 30 4 20 3 2 10 1 0 Feb-86 0 Feb-89 Feb-92 Feb-95 Feb-98 Feb-01 Feb-04 Feb-07 Source: Thomson Financial Datastream. 44 ISSN 0378-651X © OECD 2007 An Overview of Hedge Funds and Structured Products IV. Hedge fund performance, fees and costs Table 3 shows hedge fund composite performance reported in Thomson Financial Datastream versus the MSCI global equity index. These returns are net of MERs (management expense ratios, arising from trading), incurred as costs to make the returns, and fund manager costs. Hedge fund performance has been declining Three things stand out: (1) hedge funds have managed to outperform the global index on average, but not every year; (2) hedge fund performance is correlated with global performance, but does much better relatively when equity markets are weak or falling (good diversifying characteristics); (3) both total and relative performance have declined in the 2000‟s. Table 3. Hedge fund performance Year 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Av 1991-99 Av 2000-06 Equities World Index 16.0 -7.7 23.1 4.1 14.4 10.9 11.3 19.6 30.5 -16.4 -17.6 -18.5 34.8 15.5 11.2 21.3 13.6 4.3 Hedge Fund MSCI Universe 32.2 21.2 30.9 2.6 25.7 18.0 18.3 7.9 26.4 15.0 7.6 2.5 15.4 6.9 8.1 11.3 20.4 9.5 Ret Diff 16.2 28.9 7.8 -1.5 11.3 7.1 7.0 -11.7 -4.2 31.3 25.2 20.9 -19.4 -8.6 -3.0 -10.0 6.8 5.2 Source: Thomson Financial Datastream, Hedge Fund MSCI universe. Hedge funds have to spend a lot to make a lot Hedge funds‟ massive share of turnover means that they pay a lot to investment banks for their activities (execution costs), and the funds have to pay their fund managers very well. MERs are very high for hedge funds, compared to mutual funds (due to turnover). Broking estimates suggest 45 ISSN 0378-651X © OECD 2007 Financial Market Trends, N°92, Vol. 2007/1 that about 25% of the pre-MER-traded returns are absorbed by fees paid to hedge fund managers, and around 20% are absorbed by execution costs to prime broker dealers, i.e. about 45% in all. So for the 11.3% return in 2006, hedge funds would have earned 11.3/(1-0.45)=20.5% before MERs. Which pushes towards more leverage The point here is that to generate double digit returns to investors, hedge funds would have to try to earn raw preMER returns of 20% or so, and this further pushes pressure towards more leverage (to gear up the return from investing in low risk and return spread trades). V. Hedge fund styles Long-short styles dominate A summary of the different styles of hedge funds and the proportion of the market they occupy is shown in Table 4, based on Hedge Fund Industry Research data. An indication of the broad activity involved in the style is shown on the right hand side. Most of these strategies are long-short in nature: all of the equity hedge (e.g. long a stock and long a put to hedge its fall); most of event driven (e.g. buy the target M&A company and sell the buyer); all of relative value arbitrage (e.g. buy the London listing and sell the Sydney listing if an arbitrage spread premium opens); and all of sector, convertible arbitrage and equity market neutral. The macro (e.g. long only) and other (e.g. corporate governance activist, structured products, etc.) categories include directional riskier plays. Low-risk spread trades require leverage to make returns The dominant nature of this long-short or spread trading activity explains why hedge funds do so well in market downturns (i.e. it is not directional). But it also explains why leverage needs to be relatively high: investing in a strong stock market generates strong returns, while investing in a low-risk spread in a long-short strategy does not. So the trade has to be levered up a number of times in order for the spread trades to generate competitive returns (while keeping the benefit of avoiding directional risk in the market). This understanding of how the various styles work, together with the return and MER cost information, can be used to get some idea of overall hedge fund leverage. 46 ISSN 0378-651X © OECD 2007 An Overview of Hedge Funds and Structured Products Table 4. Hedge fund styles Style % Equity Hedge Event Driven Relative Value Arbitrage Macro hedge Sector Distressed securities Emerging markets Equity non-hedge Convertible arbitrage Equity market neutral Other TOTAL Equities activities Long short activities 29 14 13 11 5 4 4 4 3 3 10 100 61.0 72.5 Nature of Strategy Stock+deriv strategies M&A, spin offs, bankrupcy re-org Listing same security in 2 diff mkts Directional plays Long one versus another heavy dicount work outs Equity and debt Activist raids Buy convertible sell stock Long one stock short another Note: The equities activities are very approximate and (apart for obvious categories) assumes ½ of event driven, ½ of relative value arbitrage, ½ macro, ½ of emerging markets, ½ of convertible arbitrage, and none of other is equity related. Long-short (apart from obvious categories) assumes 75% of event driven, ½ of other, and none of macro, distressed securities and emerging markets is of the long-short variety. Source: Hedge Fund Industry Research Report Q3 2006. VI. Implied hedge fund leverage Data on hedge fund leverage is difficult to find, and more work needs to be done in this area It is difficult to find data on hedge fund leverage, and more work needs to be done in this area. Illustrative calculations based on the nature of returns and the type of hedge fund activity can be used to infer some idea of the amount of leverage involved. These calculations show that hedge funds are likely to be somewhat less levered than banks and broker-dealers. This is as it should be, since banks come within the purview of regulation and supervision, and benefit from lender-of-last-resort facilities – they can take on more risk. A simple calculation to imply leverage The calculation is shown in Table 5. The fund styles are combined around the nature of returns: (a) low returns for fixed income arbitrage, about USD 97 billion in AUM – and 47 ISSN 0378-651X © OECD 2007