Brad Setser

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Cross border flows, with a bit of macroeconomics

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I thought hedge funds were supposed to be hedged

by Brad Setser
May 24, 2006

… against market downturns. 

Wasn’t a key selling point of hedge funds that they could make money even when the (US) stock market was falling, unlike mutual funds?

Well, hedge funds may be hedged against a fall in the US stock markets, but it sure doesn’t seem like hedge funds were (fully) hedged against falls in the stock markets of many emerging economies.   Or jitters in commodity prices.

I fully realize hedge funds do a whole lot of different things these days, and that in many ways the name "hedge fund" doesn't tell you much about what a fund really does.  Hedge funds can do things mutual funds cann't do, but that doesn't mean that they all do the same thing.  Or are all fully hedged.  Directional macro bets aren't "hedged,"  and long-short funds are only hedged v. certain risks, not others.  Those betting on credit spreads are long credit risk, even if they have hedged their interest risk and so on.

But it sure seems like everyone in the 2 and 20 world was piling into to emerging market equities a while ago.   It was an easy way to make money.  Hedge funds following different strategies all seemed to be taking the same long position.  So I am not totally surprised a lot of funds have losses.

Hedging a long emerging economies position with a short on the S&P sort of works, but not entirely.  Sometimes emerging market fall more than other markets.   And I don't think many folks were long say Turkish banks and short the broader Turkish market, or long Brazilian mining companies and short the broader market.  Most bets were simply long Turkey or long Brazil.

Among my current worries: the temptation to make money (lots of it) by selling insurance against a more volatile world when volatility was falling may have been too great for some folks to resist.   Paul McCulley:

With policy makers removing sources of volatility risk from markets, actual volatility falls, which like gravity, pulls risk premiums – the market compensation for underwriting volatility – lower. More specifically, P/Es rise, term premiums narrow, credit spreads tighten, and implied volatilities in options fall.

As this process unfolds, the forward-looking return on risky assets falls, but their real time actual return is heady, as lower risk premiums are capitalized. This is a perfect prescription for bubbles.

Well said.  The real time return – not the forward looking compensation for taking risk – may have come to dominate too many (financial) decisions.  I am one of thosecurmudgeons who thinks a more unbalanced world will likely prove to be a more volatile world.  We will see.

Note: I edited a few paragraphs to try to clarify my intent.  I did not mean to imply all hedge funds are fully hedged against all risks.  I was trying to use a bit of irony.  I did mean to imply that a lot of funds following different strategies had lots of directional exposure to emerging market equities.  Folks who were long say Brazil were long Brazil and a lot of other emerging markets — long the local equity market and long the currency.   The hedges (offsetting shorts) that didn't cost an arm and a leg were global hedges.   If I am way off base there, let me know!


  • Posted by Guest
  • Posted by Guest

    Is price stability enough?

    Mr White explains booms and subsequent busts as follows: “Buoyed by justified optimism about some particular development, credit is extended which drives up related asset prices. This both encourages fixed investment . . . and increases collateral values, which supports still more credit expansion. With time, and underpinned by an associated increase in output growth, this process leads to increasing willingness to take risks (‘irrational exuberance’), which gives further impetus to the credit cycle . . . Subsequently, as exaggerated expectations concerning both risk and return are eventually disappointed, the whole process goes into reverse.”

  • Posted by Guest

    The Long View: Summer in the city could be sticky

    This column takes the “long view” and what is important for investors is whether this current turmoil will be extended. There are currently two all-encompassing views of the future of the global economy and financial markets. Both are plausible. Alas, they disagree violently. The recent market turmoil suggests the assumptions behind those views are being put to the test.

    This week, Peter Oppenheimer of Goldman Sachs produced an excellent summary of the bullish case, albeit with the ugly title of Globology. His argument is that the opening-up of the global economy resembles the industrial revolution; it is producing a sustained rise in the economic growth rate without inflationary pressures.

    A 25 per cent jump in the global labour force since 1990 (as ex-communist countries become part of the global economy) has shifted the balance of power in favour of the corporate sector and away from labour. The emergence of low-cost centres of production has slashed the prices of manufactured goods. At the same time, the widespread use of technology has enabled companies to run their businesses much more efficiently.

    All this has allowed profits to rise to a high level of gross domestic product (following a big dip after the bursting of the dotcom bubble). This level of profitability, believes Oppenheimer, can be sustained. Companies in the west have outsourced production (a significant source of volatility) to Asia. But the big rise in exports has allowed Asian countries to build up foreign exchange reserves, reducing the volatility of their economies.

    A world of stronger growth, low inflation and less volatility should be very good news for risky assets. Those who took this view naturally had a positive outlook for equities.

    The bears would dismiss these arguments as the classic “it’s different this time” rationalisation of the bulls. If profits are at a high, relative to GDP, that is a cyclical phenomenon. That should mean that investors give equities a lower valuation than average, as future profits growth is likely to be slower than GDP.

    The bears argue that the sharp rise in asset prices is simply a function of loose monetary policy. The rise in US core inflation, announced this week, will convince the inflation worriers they are on the right track. Whether things will become quite as apocalyptic as they suggest is hard to tell. But one thing does seem clear. The rosy assumptions of the optimistic school have come under question. The trade-off between growth and inflation may not be as good as they suggest.

  • Posted by Guest
  • Posted by ReformerRay

    “Down the0 road, if India also succeeds in pushing into manufacturing while China makes successful forays into services, the same question becomes all the more challenging to the world’s major industrial economies. Protectionism is the biggest risk in all this. IT-enabled globalization is pushing economic development into both manufacturing and services at a breakneck pace. Moreover, IT-enabled connectivity has increasingly transformed once non-tradable services into tradables — and has moved rapidly up the value chain and occupational hierarchy in doing so. The result is a mounting sense of economic insecurity in the developed world that has become a lightning rod for political action that, unfortunately, has been manifested in the form of an increasingly worrisome protectionist backlash”. (from Stephen Roach).

    The references to other articles found above is very helpful.
    Mr. Roach has much to say that is valuable.

    Stephen Roach asks the crucial question: “What role will the old developed economies play in the new economy dominated by China and India?” It is a question all reading this thread need to consider.

    Instead of speculating about some possible good actions the developed nations can consider, Roach worries about the possiblity that this situation will produce a “Protectionistic Backlash”.

    Classical protectionism, protecting a favored industry from international competition, has been so throughly discredited as to be automatically rejected without thought.

    I keep insisting that a form of protectionism can be developed which avoids all the problems of the classic form and provides a desirable next step for the U. S. Mr. Roach apparently cannot conceive of any other form of protectionism other than what we have always had. Regetable close-mindedness.

    It seems quite clear to me that the open borders tradition in the U. S. is reducing the survival ability of the U. S. as a major country and that the insecurity noted by Mr. Roach is realistic, not paranoid anxiety.

    What does he suggest the U. S. do? Nothing? That is the only answer operative today. Doing nothing will not relieve the anxiety because it will do nothing to stop the step decline of the manufacturing industries in the U. S. and the movement of U.S. assets overseas.

  • Posted by ReformerRay

    Question: Did Adam Smith have it right when he isolated specialization and increase in the size of markets as the two changes that increase National Wealth as import competition forces economies to become more efficient?

    Probably accurate in his day.

    Today the conversion of underemployed workers on unproductive farms to productive manufacturing employees, at very low wages, seems to be the driving force increasing national wealth in the underdeveloped countries. This appears as an unstopable force. Much more powerful than increase in specialization and market size, though those two factors are necessary conditions. Underemployed labor will be the third factor that will be the attraction for investment in the future. However, only in countries that have a stable government that can establish law and order and a banking system and welcomes foreign investment. The supply of underemployed workers seems much larger than stable, forward looking governments.

    In stead of trying to dominate the world by military force, the U. S. should be looking to develop ties with those countries that have the right kind of government and the supply of underemployed workers. Give up the idea of exploiting those countries. We need them to grow strong on their own, as an alternative to China.

  • Posted by Guest

    China and India: The Reality Behind the Hype

    Borders without visas [cf. “In the real world, currencies deviate so far from presumed purchasing power parity values as to make a mockery of the concept. Why? Very simple: there is no free and open global market in citizenship. Sovereign countries retain the power to print passports and visas. In turn, sovereign governments – especially democratically-elected governments, but also governments with democratic tendencies – must be responsive to their citizens’ needs and wants, not global citizens’ needs and wants. Thus, sovereign countries should and do have the ability to print their currencies in sufficient volume to keep them undervalued on purchasing power parity terms. It’s called mercantilism.”

  • Posted by DOR

    One of the problems may be the definition of terms:

    _ _ _ _ _ _ _ _ _ Short term _ _ _ Medium _ _ Long
    Economists_ _ _ _ _ _ _> 12 mo _ _ _ _ 1-3 yrs _ _ _3+ yrs
    Futurists_ _ _ _ _ _ _ _ your life _ _ _ _ 100 yrs _ _ _ 500 yrs
    Banks__ _ _ _ _ _ _ _ _ > 30 days _ _ 30-120 days _ _ over 120 days
    Stock markets_ _ _ _ _ _ 2 weeks _ _ _ 3-6 weeks _ _ next quarter
    Currency markets_ _ _ _ 30 seconds _ _ 30 minutes _ _ after lunch

  • Posted by FTX

    Hmm. When you get double posts with incorrect formatting, it kind of takes away the impact of what you were trying to say, doesn’t it…

  • Posted by Guest

    “This month’s sell off in Asian markets will shake out the region’s weaker hedge fund managers, but rich trading opportunities should ensure the sector’s growth for years to come, industry experts said on Thursday. Fund of fund managers, who invest millions with hedge funds on behalf of pension funds and other large players, said the volatility will ultimately benefit the best managers. “It’s a good test for managers here. If you look at the past four to six months, markets have just been running away, and you can’t really tell who’s good and who’s not,” Jerry Wang, chief executive officer of Vision Investment Management, told an investment conference in Singapore. “Essentially the higher the beta (volatility) the better. And I think what’s happened in the past week or so will enable us to separate the men from the boys.”…”

  • Posted by Guest

    Sorry to get off topic, but, Reformer Ray – generally a bit tired of the comments U.S. military domination and exploitation. Lots of other nations with similar aspirations who will play the game, with or without the U.S.:

    “In its annual report to Congress on China’s military strength, the Pentagon also noted that China was increasingly using what the report called “legal warfare” to shift international opinion and deflect through legal arguments international criticism of any moves toward Chinese military action in the Taiwan Strait. The report puts the number of Chinese ballistic missiles facing Taiwan at 710 to 790, and estimates that China is adding some 100 such missiles annually, a pace that is accelerating, with newer versions featuring improved range and accuracy… China has already received the first of two Russian Sovremenny II guided missile destroyers, with the second expected by the end of this year or next year, the report says. The destroyers are fitted with advanced anti-ship cruise missiles (ASCMs) and sophisticated wide-area air defense systems…”

  • Posted by Anonymous

    Stick to economics…if funds were “fully hedged” you would replicate a risk-free return by definition. Hedge funds take risk. Mutual funds take risk. Mutual funds have fewer degrees of freedom. It stands to reason that the return per unit of risk will higher for those subject to fewer constraints.

  • Posted by bsetser

    FTX — your incomplete post included a open italics sign — i edited it out and took down the incomplete post.

    Anonymous. Of course hedge funds are fully hedged.

    But I have been struck my how many hedge funds have been basically taking the same set of risks recently. Everyone piled into emerging market equities. Everyone. Classic herding, from some very sophisticated folks.

    And as a result, lots of players with higher degrees of freedom had rather correlated positions. Why did oil exporting and oil importing EM equities all sell off recently? Presumably because they were linked together by a common set of investors.

    Long/ short equity strategies that are long EM/ Short USA are effectively directional macro bets on emerging economies.

    Do you disagree?

  • Posted by bsetser

    Anonymous — One other point. In theory, HFunds can improve market efficiency by being on both sides of the market. I believe that is often the case. But I strongly suspect that being short EM equities during the recent run up has been far too costly, so all the geared players were on one side of the market.

  • Posted by OldVet

    bsetser, I think DOR’s observation about time lines of thought is right, in that we are having two or three discussions simultaneously with correct answers that may conflict depending on the time line. (much as I don’t want to agree with DOR today.)

    Not all hedge funds actually hedge in truth, as many investors are finding out now. But in the long run investors would be better off accepting the short term risks of Emerging Markets in order to reap the long term benefits. It would probably be cheaper in the long run to dispense with the expensive services of the hedge fund managers. In the short run, that would not have appeared to be the right answer.

    Likewise the short run economic needs of populations in the Western industrialized world may differ from their long run economic needs. In the short run they need cheaper goods and services because their wages are stagnant or falling. In the long run they need jobs and/or investments that will provide income in a changing world. Hedging agains risk – short term risk ?- is not a substitute for financial market and real market changes to meet those needs. Nobody can heldge against long term changes, as is most obvious to speculators in currency markets.

    The sticking point is that living standards are equalizing more rapidly than total global wealth creation. That gives the short term reality to the fear that US living standards are falling at the expense of rising living standards in other countries. In the short term, US policies might need to stimulate import substitution in order to cushion jobs. For the long run, the US can take other measures that stimulate new job creation for which it is hard to trade/substitute.

    As has always been clear, the beneficial interest of investors may have nothing to do with a particular group of workers. The frictions arise when investors sneer at wage-takers and move their jobs, or when workers team up to halt investors from maximizing returns. Labor markets are much more “sticky” than investment and financial markets. Sort term versus long term, there you have it.

    Creating new industries takes longer than pushing a button in financial markets.

  • Posted by Guest

    Anonymous – sorry, and correct me if I’m wrong, but it’s my impression that arms deals are a big part of economics. Rather than blame everything on Western hedge funds and Wall Street, might it also be prudent to consider the possibility that some of the EM profit takers may have been the EMs – and that those profits may be re-invested in untransparent ways with the intention of supporting their own military/ hegemonic aspirations?

  • Posted by psh

    ‘Long/ short equity strategies that are long EM/ Short USA are effectively directional macro bets on emerging economies’

    I’m thinking it doesn’t have to be directional. You can be beta-neutral without being dollar-neutral, and get the benefts of relative outperformance. Not exactly. The gnomes who try to do that, they think in terms of wealth transfer, which can happen with or without growth.

    ‘military/hegemonic aspirations’

    hmm, lemme put on my tinfoil thinking cap

  • Posted by Laurent GUERBY

    According to wikipedia, even the first “hedge fund” was partially hedged 🙂

    For hedge funds, who takes the risk?

    – People who willingly give their money to HF
    – Banks lending them money (to people buying HF or HF directly)
    – Banks selling HF derivative (or may be buying some from HF).

    As long as bank to HF lending is duly monitored by financial authorities, as is risk management in banks who sell derivatives, there is not much risk except of course for HF investors, but they’re supposed to know that :).

    I know that regulation and public oversight is not fashionable there days, but in our current system of fractional reserve private banks have been given the not so natural right to create money out of thin air, and this right should not come for free or we will all pay for it :).

    Not directly related, how do one find the amount of equity liability of firms (publically traded should be easy, but also of privately held)?

  • Posted by Andrey

    bsetser. “Of course hedge funds are fully hedged”

    “Hedge fund” today means the type of organization of an investment fund, not the strategy the fund uses. Some hedge funds are long-only funds. Hedge funds make money by taking risks, if a hedge fund “fully hedged” i.e. doesn’t take risks then it means that the hedge fund can’t make money above risk-free rate.

  • Posted by bsetser

    Andrey — I should have made that point clearer. I agree. I was trying to be a bit ironic, but it led to a bit of confusion …

    my real point was that a lot of folks were making the same long bet — long em equity. whether directional global macro plays or long EM equity/ short some other equity market. the net effect was a concentrated long position among leveraged players. At least that was my sense, largely based on a few anecdotes and a few friends in the business.

    I need to think about psh’s point.

    old vet — tend to agree that there is a good long-run case for emerging economies. but i also tend to think there a lot folks were piling on to last years big gains earlier this year in a somewhat indiscriminate way. real money folks (the inflows into EM mutual funds). and the hedge fund crowd.

  • Posted by OldVet

    Correct – but as a long term investor in EM, I’d like the short term speculators to know we love them and want them back. Bring cash, please, and less credit next time.

  • Posted by DF

    I thought that the 30’s had taught us that financial innovation was a code word for dangerous speculation …
    If Bernanke’s such an expert of the 30’s how come he’s not calling for tougher regulations on those hedge funds.

  • Posted by Anonymous

    Sorry, anonymous here, I was busy buying EM stocks!! HEHE. Seriously, my only point was really that hindsight trading is always 20-20. Yes, there is herd mentality. Yes, the consensus is eventually wrong. I would encourage those evaluating markets to trade a small amount of their personal wealth, observe their behavior in uncertain times. It is far from trivial and often you too will find yourself with the herd. Try and find anyone out there who is really dollar bullish. Yah, there are a couple but the “smart money” is wildly dollar bearish. Is that a good reason to be bullish? I hope not! Alternatively, recall the 2001 period when the “world” was long eurodollar futures on expected FED rate cuts. There were violent backups but in the end being long ED futures was the right trade – the fact that it was a consensus trade merely added unncessary volatility and reduced sharp ratios. The herd was right, even though at times they seemed nutz.

  • Posted by Guest

    small comment re. Brasil

    anyone who took the not-so-short time to, in early 2002, fully analyse that economy in conjunction with Argentina and rest of MERCOSUR, and of course changing relations with rest of world AND combined this with an understanding of the region’s and Brazil’s politics, would very well have known that the probability of Lula’s election would further knock that market. But, and exactly contrary to the financial press, he had been moving to the right for years and would stay with ‘generally acceptable’ policies – as this sunk in, that market would take off. It was as close to 100% as anything that I’ve seen in decades. Always look for the contradictions.

    sure enough, foreign flows picked up very substantially, and as seems the norm helped generate overpricing. Any funds still long Brazil at the beginning of this year simply lost sight of basics,,’deserve’ the consequence.

  • Posted by Anonymous

    The problem is that we live in a one world economy where what happens in one market is quickly reflected in other markets.

    In other words in today’s world you do not hedge a bear market in US equities by buying equaties in other markets.

    If you want to model the Canadian bond yield the first thing you but in your model is US rates. In the old days you could explain US rates with strictly domestic variables. But that is no longer true. Now you can not model US yields without including foreign yields any more then you can model Canadian yields without including US rates. What we are now seeing is a drying up of “world liquidity” that drives stocks markets in all markets down , not just the US.