12 Dec 2008 - Tammer Kamel
With so many funds now gated and inventing new share classes to effect “orderly” liquidation or to capture “unprecedented opportunities”, investors must decide who gets a renewed mandate and who gets fired. Making the decision is a difficult but not intractable problem. It will hinge on two things: how the manager navigated the second half of 2008 and, more importantly, did risk management actually work.
I want to single out a particular risk management mistake made by many investors this past year that is inexcusable. Any portfolio manager, (hedge fund, fund of funds, investment advisor, etc) who combined leverage with illiquidity made an elementary and catastrophic mistake. The dangers of mixing the two are not only simple to understand but thoroughly documented and empirically proven.
Leverage has always been an effective tool for amplifying returns, something that even the seminal hedge funds of the 1950s employed. However, they also held highly liquid portfolios. It is their modern descendants that have ventured to less liquid markets, reaping rewards earlier this decade. But there is little else in finance that is more dangerous than the combination of leverage and illiquidity. An entire generation of investors are now learning this lesson at high cost.
But actually, there is no excuse for making this mistake. Any professional investor who makes it is bordering on negligent risk management because it is so obviously dangerous and so easily detected and thus easily mitigated. It only takes two tick boxes on one’s due diligence check list; one that says “leverage” and the other that says “illiquidity”. If both are checked, you’re done. Other aspects of risk management can be more nuanced, but keeping leverage away from illiquidity is risk management 101.
Leverage and illiquidity lead to a death spiral. There is no end to the case studies available, but 2007 offered a particularly stark one that turned out to be one of last of many warnings investors were offered before the bloodbath of 2008.
The Basis Pac-Rim Opportunity Fund had enjoyed some six years of success leveraging modestly (1.3x) into structured credit, (read illiquidity). When sub prime started unraveling in early 2007, the firm entered the classic death spiral: margin calls led to forced selling of securities that had no market and hence no buyer. Having no other option, the fund had to sell at an extreme discount thus establishing a new mark to market for their remaining holdings thus triggering further margin calls and so on. (Figure 1.)
This is the classic illiquidity + leverage death spiral and it predates hedge funds by at least 500 years which is why the “unprecedented market conditions” mea culpa is rubbish. Every fund that mixed illiquidity with leverage is negligent and probably because they were blissfully ignorant of basic financial theory and 500 years of financial history. No manager should be excused for this. Basis Capital should not be excused nor should the various fund of funds who ignored the risk and invested in Basis. And the same is true for the hundreds of managers who made the same mistake this year and whose losses were doubled or tripled as a result.
Due Dilligence 101
