Market conditions today are very similar to those that investment professionals managing funds found themselves dealing with during 2008 :
- the re-emergence of rumbles of uncertainty and instability in relation to the banking system and
- a Euro falling in value against the US dollar.
When investors look at funds of hedge funds they often forget that discussions on liquidity should not simply focus on the liquidity of underlying fund investments but also on credit facility management and the pressures put on the currency hedging that the fund needs to do.
Fund of hedge funds like their underlying investments need to provide collateral to obtain financing. In addition on hedging transactions cash margin needs to be posted. It is not unknown for a fund of hedge fund to move an investment from one portfolio to another simply for the expediency of being able to raise some money for the margin calls required for a currency hedge that has gone the wrong way. And right now Euro denominated funds investing in US Dollar denominated underlying assets will be feeling some liquidity pain.
How does this work? Lets say a manager has two funds A and B. Fund A receives a $100 worth of subscriptions. Fund B has no subscriptions and all its assets are under a 12 month lock. Let us also assume that the buffer of cash for the currency hedge has been exceeded on both funds so there is a requirement to raise additional funds of $50 to post margin on both funds. Where does the investment manager raise the $50 in relation to Fund B? If he has exceeded his buffer calculation for the hedge he is in trouble because his funds are under lock so he cannot get to them. In this scenario he readjusts his portfolios – he finds an asset held by Fund B which because of the way the investment’s ownership is recorded in the underlying funds books can be moved to Fund A without triggering the lock provisions because there is no record of a change in beneficial owner as the owners reference is just the common custodian reference that the investment manager uses for all his funds. A very common practice among managers with several funds.
In this way Fund A receives $50 worth of assets and Fund B receives $50 of cash which it is then able to post as margin.
Surely there is nothing wrong with that? On the face of it there may not be – Fund B clearly needs to raise margin and has achieved its objective. Fund A may have wanted that particular investment and the $50 has been utilised appropriately to get exposure to that particular strategy. There is nothing sinister in the shadows and the compliance officer is happy that all is well in the garden.
But what if the receipt of the $50 worth of investments in Fund A was not appropriate to its strategy? What if the benefits to Fund A of receiving those investments is not all that clear cut – or even has an impact on its performance? Well then surely the transfers have only been for the benefit of Fund B? Surely the investors in Fund A (unbeknownst to them) are bailing out the investors in Fund B facing a major liquidity issue if they are going to remain hedged in relation to their currency risk? If investors were to start examining the internal transfers of assets that occur within the fund portfolios of an investment manager they may find that a story unravels which whilst it keeps the investment manager’s portfolios squared up is not necessarily strictly in the interests of both the receiving and transferring fund. Can proof for such accusations be found? It would take examination and the evidence may be circumstantial but investment managers would begin to find explaining some of these transfers quite difficult other than for the expediency of managing liquidity in one or the other of their funds.
Given current market conditions investors doing due diligence on hedge funds would be well advised to look at the extent to which there have been internal portfolio purchases and sales as that is likely to give them a far better insight into how portfolio liquidity is being managed than any marketing presentation on the seriousness with which they take liquidity issues on a fund. It would have the makings of an interesting conversation and draw away from the shadows a practice by fund managers that should be capable of scrutiny.
©Jaitly LLP