Decomposing FoHF returns
Where and when funds of hedge funds add and lose value
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09/06/2010
Comment: Marc Russell-Jones
“You never want a serious crisis to go to waste”. The now infamous phrase of Rahm Emanuel, President Obama’s Chief of Staff, regarding the credit crunch has already entered the vernacular. Politicians, legislators and regulators in Europe and the US have enthusiastically embraced his message and embarked on severe, and sometimes misplaced, regulation of financial services. The new requirements will have a profound effect on the alternative investment industry, however, it is the self-imposed changes that may have a more long-lasting impact. One area where this may occur with respect to hedge funds is in their approach to short-term cash, in particular, their desire to post their initial margin with third-party custodians rather than maintain it with prime brokers.
The prime broker operating model was severely disrupted by the turbulence in financial markets during 2008 and 2009. Lehman’s collapse was just one example of an event that caused hedge fund managers to re-assess their approach to counterparty risk. This resulted in the movement of long assets and unencumbered cash to third-party custodians. The questions that every chief executive wanted answered were: Where are my assets? Where is my short-term cash? What is my AuM?
Two years on, these questions have largely been addressed. BNY Mellon has played an important role in supporting the traditional prime broker model, which clients rely on for stock loans and financing. On the other hand, the prime broker/custodian (prime custody) model has continued to evolve, especially as hedge funds have focused on derivatives collateral management, verification of margin calls and the posting of initial margin into products such as our Margin Direct product offering.
Margin Direct allows hedge funds to collaterise initial margin with BNY Mellon through our money market funds portal via a pledge structure. We believe that the trend towards collaterising the initial margin with custodians will continue. In support of this perspective is the fact that since the introduction of our Margin Direct offering, cash balances have been increasing at an exponential rate.
While the immediate threat of counterparty risk has diminished from the apex of the financial crisis, it is foolhardy to suggest that it has been eliminated or that it will not rear its head again in the near future. This is especially pertinent today when one observes the ongoing issues with European sovereign debt and the wider ramifications that could occur if the situation continues to worsen.
Simply put, in this new and still uncertain paradigm, one can never be too cautious about counterparty risk. That which we knew to be true in the past, does not necessarily hold in the present, and even less so for the future. Thus, it is both prudent and pragmatic for hedge funds to structure themselves in such a manner as to alleviate as much risk as possible. The use of money market funds and pledge structures to hold short-term cash is one such way of achieving that aim.
Marc Russell-Jones is managing director at BNY Mellon Alternative Investment Services
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