After contributing their fair share to the more than $1 trillion in estimated global financial industry losses in this credit crunch, hedge funds appear to be on the mend. However, the alternative investment vehicles known for returns that are uncorrelated to broad market indexes will, in Standard & Poor's Ratings Services' opinion, likely require more than deft trading strategies to return to their former glory days and once again attract investors.
We believe investors will consider other key differentiating factors. Transparency, for instance, appears to have surpassed performance as a criterion for choosing hedge funds.
We believe the industry is moving toward a more favorable outlook as the economy shows signs of bottoming out and traditional fundamental measures of value return to prominence. The sector has certainly benefited from more stable investor outflows. And although the rate of overall inflows may not be what it once was, we believe the industry will continue to grow, albeit on more onerous terms than those to which managers had grown accustomed. We've also seen a reduction in market volatility from historical highs and less competition. And many alternative investment managers have indicated that they are adding high-level and experienced talent without having to make costly compensation guarantees.
Using Leverage Sparingly The one major uncertainty for the sector, however, continues to be regulatory reforms. Traditionally, hedge funds have been able to take both long and short positions in any instrument, in any cash or derivative markets, without restrictions by regulators. But that may change in the coming year. We believe most hedge funds are anticipating stringent regulatory and reporting requirements and are adapting accordingly. Funds and investors are also monitoring temporary government support. The manner in which this support is withdrawn from the market may create opportunities for hedge funds.
Despite hedge funds returning to positive performance, we believe investors will be looking at more than just returns in the future. The recent market crisis highlighted four factors of increased importance.
Most rated hedge funds with a 10-plus year history have generally understood that they can succeed or fail by leverage—borrowings or embedded leverage in instruments that can magnify both gains and losses—and have accordingly used it sparingly. Some funds have come to shun the use of leverage altogether because of its inherent risk. We have seen funds with historically low leverage (1 to 2 times total assets to risk capital) reduce it even further as a result of the experience of the past 18 months. As we note in our rating criteria, with high leverage comes the high likelihood that cash flow will be insufficient to cover costs and adequately compensate key employees, leading funds potentially to close, if not default.
We evaluate the level of leverage in a fund from an absolute basis—the debt-to-equity ratio—but also adjust this ratio based on several factors, including embedded leverage of the instruments and the volatility of the asset values. In general, we believe investors will be more attracted to hedge funds that use low to modest balance-sheet leverage relative to their investment strategy in conjunction with a strong risk management system, which should enable them to respond to market changes more promptly.
Building Investor Goodwill As with leverage, investors will likely increasingly judge a hedge fund based on the transparency of its dealings with all its business partners. As we note in our criteria, the highest-rated funds are those that provide the greatest transparency and demonstrate the most developed infrastructure and culture of risk controls. At the most basic level, we look for management's willingness to communicate and seek ways for investors or service providers to attain the assurances they need. In some instances, managers have achieved this by engaging agreed-upon procedures with an independent third party such as an audit firm. Where a sensitive matter such as investment strategy is concerned, funds may use dated examples to bring across the relevant points in public statements. In some cases, we've observed funds create investor letters with sufficient detail that investors can adequately judge the merits of performance and risk attribution.
Many funds have realized that the benefits of being transparent outweigh the potential cost from the outset, enhancing investor goodwill. After all, during times of uncertainty, such as the recent financial crisis, investors' focus seems to shift to return of capital from return on capital.
Investors have become wary of hedge funds' use of gating, which can limit the amount of total outflows that can occur at a given time. Historically, gates were used to benefit investors by preventing them from exiting en masse, which could cause the fund either to collapse or to sell assets in a down or illiquid market. Investors understood that management would only gate if it intended to regain its prior years' losses, or a "high water mark." It expected the fund to make the money back or shut down and pay it back to investors. However, some hedge fund managers used gates because in the lead-up to the crisis, what they believed to be liquid investments turned out to be less so, and that caused managers and investors great losses. Funds also used gates to provide a safety net for the fund's own liquidity shortfalls.
Crisis Led to Simplification As a result of these actions, fund managers who engaged in such practices for the wrong reasons may have lost investor goodwill. We believe that many investors that have been gated will redeem their holdings when funds lift their gates. And investors are likely to be cautious of similar gating structures in the future. They will also look for more stringent reporting on investment portfolio liquidity—asset liquidity, collateral management, covenants and other triggers, and redemption risk.
In many instances leading up to the crisis, credit risk rose due to the concentration of illiquid positions held in funds' portfolios. While it's difficult to quantify the risk of asset liquidity, we believe sound risk management systems should also adjust the dollar value of risk by a particular factor to account for the liquidity of a position. Historically, risk management would focus primarily on the volatility of the position (for instance, a macro fund would allow for a smaller oil position than a Treasury bond position) in addition to asset mix. By adding an additional factor to the dollar risk of illiquid assets, hedge funds can take a step to help ensure that their portfolios don't become too heavily weighted in less-liquid instruments.
As part of their risk management changes, hedge funds have simplified what they do and refocused on core skills. In some instances, they responded by reducing the number of strategies they pursue, closing locations, and laying off employees. Before the financial markets began their slide, some hedge funds took an "anything goes" investment portfolio approach, as long as they made money. As liquidity dried up, however, investors began to hold portfolio managers strictly accountable. Investors have responded by demanding their compensation from new fund investments or startups with either increased reporting requirements, transparency, or even (in the case of startups) a share in the management company.
Outperformance in Volatile Markets The ability of hedge funds we rate to weather the market downturn without requiring direct external support from governments has been, in our view, impressive. This is a testament to the sound liquidity that rated hedge funds have generally implemented, and sound risk management practices. We recognize that governments have played a large part in stabilizing markets. If growth starts to return to the economy, however, governments will likely start extracting themselves from the market, which could lead to a renewed increase in volatility, depending on how investors believe that process will evolve.
Historically, hedge funds have fared better in volatile markets because they can better anticipate or adjust to market events. We believe they continue to be very well-positioned to take advantage of these opportunities. If hedge funds add to their stronger performance so far this year, investors will take note. However, it's likely that new investment flows will only follow after investors consider all the relevant risks and not just the potential returns.