Book Review: Hedge Funds Humbled

What went wrong? The hedge fund industry had seen tremendous growth in the last decade with assets coming close to three trillion dollars. Hedge fund managers were the kingpins of the investment world—but in 2008, the industry collapsed. Only one in five hedge funds had a positive year, more than 1,400 hedge funds closed, and investors were clamoring for the doors. In Hedge Funds Humbled, Trevor Ganshaw, a partner at a multistrategy hedge fund in New York City, explores the reasons for the dramatic turn of events and describes an industry definitely in need of some humbling.

Ganshaw opens the book by suggesting that the industry was "slowly rotting from the inside out," just like pickled shark in Damien Hirst's notorious work "The Physical Impossibility of Death in the Mind of Someone Living," which was purchased for a staggering $8 million by hedge fund founder Stephen A. Cohen. Seeing the shark as also an apt metaphor for the excesses of the time, Ganshaw attributes the industry's downfall to “seven deadly sins”: excessive leverage, inadequate risk management, flawed fee structures, overcrowded strategies, capital instability, excessive capital, and, lastly, loose controls that allowed financial fraud.

As for performance fees, Ganshaw relates the structures that currently prevail to the payoff on a call option. The manager shares in the upside while it is the investor alone who bears all the downside. Furthermore, and particularly relevant for strategies of longer dated assets, investors pay fees on unrealized profits which may never, in fact, be realized.

Excessive leverage is a common cause of hedge fund blow-ups, and Ganshaw gives a detailed description of how this was the case for Sowood and the Bear Stearns hedge funds in 2007. He explains the different ways of measuring leverage, the different sources of financing and what each are typically used for, and the contractual covenants that one finds in prime brokerage agreements. This chapter supplies many useful tips for investors.

His description of risk management as “narcissistic” leaves the reader in no doubt that he is less than impressed with the risk management practices of the industry. And why wouldn’t he be? Isn’t this the industry that is supposed to make money in up and down markets? He points out that the three most virulent risks are loss of financing, illiquidity, and hedge fund correlation. Risk management systems, he feels, due to simplified assumptions and inadequate scenario analysis, gave managers a false sense of confidence and led to too high a tolerance for risk. Adequately skilled and experienced staff, he believes, are key to adequate risk management.

The fourth deadly sin is hedge fund correlation. Peak industry AUM in 2008 was just shy of three trillion dollars. Assuming this was leveraged at about two and a half times and offset by an equal value of shorts, the total capital invested could have approached $14 trillion. For reference, this is greater than the GDP of the United States. Ganshaw chooses convertible arbitrage as the perfect example to illustrate too much capital chasing too few opportunities. The strategy was the worst performing in 2008 with losses of 50%. He explains the circumstances in which the correlation problem is most likely to exist, providing investors with further useful information to bear in mind as they allocate capital.

Amaranth is the exhibit used to illustrate another hedge fund vice. Founded in 2000, Amaranth was originally a convertible arbitrage fund and produced attractive returns in its first few years. As such, investor capital poured in. However, as the convertible bond market only amounts to about $300 billion, Amaranth was forced to move into new areas beyond their core competence to continue to produce good returns. It ventured more and more into energy trading–its efforts led by a 32-year-old trader. As a result, the convertible arbitrage fund lost $6 billion on natural gas positions. Throughout the book the author urges investors to learn from these blow-ups and in this particular instance he warns that investors should be wary of managers managing ever-larger amounts of capital.

Another big problem with the industry is the instability of the capital structure of hedge funds. Billion-dollar funds (unlike billion-dollar companies) are often built on short-term equity capital and even shorter-term debt capital. This is not critical where the duration of the assets invested in is short-term, such as in long/short equity or macro strategies, but this can become a real issue when such capital is used to finance longer duration and more illiquid strategies. Managers have tools at their disposal to mitigate the instability of equity capital such as lock-ups, gates, and suspension of redemptions, but these are not all investor-friendly. Ganshaw recommends that funds seek to balance the duration of their assets and their capital in order to protect their businesses and to protect the interests of investors.

The final deadly sin, fraud, is best illustrated by Bernard Madoff. This $65 billion dollar fraud sabotaged the hedge fund world and left many investors with big losses. In this situation, Ganshaw looks on the bright side and lists what investors and the industry can learn from this fraud and from others. The author urges readers to be aware of three different kinds of funds: funds that are self-administered; funds that are audited by less reputable auditors; and funds that custody assets and do trade execution through an internal broker-dealer. Ganshaw provides a thorough analysis of the Madoff fraud and warns investors against Fraud 2.0—which does not involve theft of assets, but consists of deceptive communication from managers.

With such weaknesses in the industry, what then does the future hold? The last few years have been a lesson for investors, and now they have an opportunity to wield their increased power and to demand that changes be made to level the playing field and to ensure that their investments are better protected. The author believes that the industry can redeem itself by addressing the failings detailed in the book. He expects to see a changed landscape with bigger funds, more stable capital structures, better risk management, greater transparency, and less leverage. Yes, changes are already underway, but only time will tell the extent of these changes.

Overall, the book is interesting for those who come into contact with hedge funds and could serve as a good primer on the topic. There are plenty useful tips, explanations, and insights for investors that could help with due diligence. Explanations are thorough and there is good use of examples from real-world events. The book is well researched and many references are given in the endnotes to prompt further reading.

–Brendan O’Connell, CFA