The Fuse

Hedge Fund Turbulence a Sign of Greater Economic Troubles?

by Matt Piotrowski | November 24, 2015

A lot of big financial players have been wrong-footed this year.

The hedge fund community has come under a lot of stress. During the third quarter, hedge funds saw the largest quarterly decline since the 2008 recession and a number of big trading houses recently closed down. The string of closures, as well as an overall poor performance in the hedge fund sector, could be a sign of deeper structural issues in the economy. The global economy may not see a downturn similar to the 2008 financial crisis, but stiff headwinds are certain to remain.

The string of hedge fund closures could be a sign of deeper structural issues in the economy.

“There’ve been a lot of hedge funds closing this year. This is a function of equity markets being flat in the West and down in emerging markets, while commodities are getting slammed,” said Albert Helmig, the CEO of Grey House, a global financial consulting firm. “On top of their mediocre performance, the changing regulatory requirements coupled with IT infrastructure costs are having negative effects on some of these managers. People are affected by scale issues. You need a certain amount of funds under management to produce results. You can be too small and in some cases too large.”

Hedge funds—secretive investment vehicles that use pooled money and are typically aggressive with their trading strategies—have taken hits from lackluster equities, but there’s also been a big shake-up in commodities, with metals and agriculture seeing major losses. Despite oil price weakness and the uncertain macro backdrop, energy returns for hedge funds have actually been relatively strong in 2015.

String of bad luck

The data doesn’t show positive signs for hedge funds in general. For the third quarter, capital held by hedge funds fell by $95 billion to $2.87 trillion, the largest quarterly decline since 2008, according to Hedge Fund Research (HFR). Year-to-date, the value of a key index tracked by HFR showed performance down 2.24 percent, which follows a decline of 0.58 percent last year. By contrast, 2012 and 2013 saw gains of 3.51 percent and 6.72 percent, respectively. HFR noted that recent financial volatility stems from uncertainty over U.S. interest rates (the debate over the Federal Reserve hiking rates won’t stop), China (markets there took major hits in August and the economy is set to slow next year), and mergers and acquisitions (corporate M&A could set a record this year).

Recent financial volatility stems from uncertainty over U.S. interest rates, China slowing down, and a large number of mergers and acquisitions.

Most “macro” hedge funds—those that take positions based on global economic and political developments—are down this year, with energy as the one bright spot, seeing year-to-date gains of 3.42 percent. Grey House’s Helmig said hedge funds in oil are able to perform better than others due to active investors taking advantage of the crude futures’ deep liquidity and volatility.

Hedge funds that trade oil are typically long-only, meaning they usually bet on prices to rise. But some have shifted gears in the current price environment, with more taking positions that prices will fall. According to the latest Commodity Futures Trading Commission (CFTC) data, non-commercial players (which include hedge funds and other financial investors) in NYMEX crude futures have accumulated more than 154,000 contracts of bearish bets as of November 17, up by about 40,000, or 35 percent, in just two weeks. This is a strong indication that investors see prices falling further as a result of high crude stockpiles, OPEC policy, and worries about global economic growth. At the same time, however, once prices reverse course, it could set the stage for an accelerated rally whenever players betting on lower prices need to cover their short positions. Changes in positions among hedge funds tend to be tightly correlated with fluctuations in oil prices, meaning their buying and selling accelerate price movements in both directions. Oil prices typically fall when hedge funds add short positions or liquidate long positions, and they usually rise when hedge funds cut short positions or add length (which is betting on higher prices), although financial traders are not the only reason for price volatility. Oil market fundamentals, macroeconomic factors and geopolitical risk also play roles in causing sharp price movements.

Changes in positions among hedge funds tend to be tightly correlated with fluctuations in oil prices, meaning their buying and selling accelerate price movements in both directions.

While some trading houses focus specifically on energy, many hedge funds trade in this space solely for portfolio diversification—investors spread their risk among a variety of different assets and industries. Losses in energy may not matter all that much for hedge funds when equities perform well. In the current environment, the opposite is occurring, with equity markets underperforming, contributing to a number of funds shutting down. And despite energy’s relative strength, commodities overall are getting slammed, making it difficult for hedge funds and other investors to find gains anywhere. Metals have taken significant hits, with its index down 12 percent year-to-date, based on HFR’s calculations. The copper market, for instance, is dealing with massive inventories, limited supply cutbacks, and slowdown in demand in China.

Closing up shop

Through the first half of this year, according to data from HFR, more than 400 funds have been liquidated, and the carnage could just be starting given how many big funds have shut during the past couple of months. During the last few years, roughly 900 closed up each year, and this year might be worse. Back in 2008, amid the financial crisis, roughly 1,500 were liquidated. Just recently, BlackRock, the largest asset manager in the world, wound down its $1 billion Global Ascent Fund, while high-profile funds Fortress Investment Group, Absolute Return Capital and Achievement Asset Management have also closed down.

It’s too early to tell whether the faltering hedge fund industry is dealing with short-term issues or its troubles are signs of greater economic consternation, but some commentators argue that their problems are a big warning sign for the economy.

The funds that have gone belly-up are not household names by any means, but they are trading houses with top talent and are among key providers of liquidity in financial markets. Hedge funds used to attract the best traders and billions of dollars in capital seeking high returns, but now the entire financial services industry is having difficulty finding and keeping top talent, while it also has to deal with regulatory compliance and high IT costs that were put in place after the 2008 financial crisis to help prevent another Lehman Brothers-style meltdown from occurring.

It’s too early to tell whether the faltering hedge fund industry is dealing with short-term issues or its troubles are signs of greater economic consternation. A number of commentators have argued that the hedge fund closings, along with the fallout from low oil and gas prices and weakening consumer confidence, are warnings signs of a worsening economy. We will soon find out if that is indeed the case.