Taking their Lumps: Hedge Funds
It’s shaping up to be a tough quarter for hedge funds across a variety of strategies. I thought I’d look at a few things that have gone wrong in merger arbitrage, event-driven, and macro strategies. Along the way, I’ll try to explain what those strategies are.
Merger arbitrage is one of the oldest hedge fund strategies. The idea is to lock in the small discount between the final purchase price on a deal and the current price. The discount exists both because there’s some risk that the deal won’t close and a time value to money. After the deal is announced, many shareholders are ready to move on rather than waiting for the deal to close. Merger arbs are willing to take on the risk, for a price. As more and more hedge funds have flooded into merger arbitrage, the returns from the conventional and conservative practice of the strategy have shrunk. As a result, many hedge funds managers moved into riskier deals such as unsolicited takeovers or jumped into a slightly different investment category: event-driven strategies.
An event-driven strategy is a bet that a company will take some action that makes the stock jump. It might be a huge dividend payout, the spin-off of a business, or a corporate restructuring. In today’s market the line between merger arb and event-driven strategies is often blurry. In either case, the managers conduct research and try to track down rumors in order to make sure that the needed regulatory approvals, debt financings, shareholder approvals, or executive decisions come through. A well-structured merger arb or event driven portfolio should consist of investments in a broad range of situations. The idea is to consistently gather up the small change that other investors are willing to give up.
This week many merger arbs were run over. When a couple of bets go badly wrong, it can wipe out a sizable portion of a hedge fund manager’s portfolio. Twenty-first Century Fox’s $75 billion unsolicited offer for Time Warner fell apart. Rupert Murdoch decided that he could not finance the deal. Many merger arbs were long Time Warner either by owning the stock or options, expecting the company to be taken over. They were also short Twentieth Century, the idea being to lock in the spread between the acquirer and acquiree. When Mr. Murdoch pulled the plug, Time Warner’s stock fell 13%. Meanwhile Fox gained 4%. Suddenly the arbs were wrong on both ends of their trade, and if they’d put the bet on by using options, being wrong was even more painful. Some short-term Time Warner options dropped by 99%.
One bad deal can be manageable. However, Sprint’s acquisition of the T-Mobile deal also unraveled due to regulatory concerns. The arbs were caught by surprise.
The event-driven world got a nasty surprise from Walgreen’s. Hedge funds were confident that Walgreen’s was going to do a corporate inversion and wind up with a much lower tax bill. While Walgreens has announced that it will acquire the rest of Alliance Boots (it already has a minority stake), it isn’t going to use Alliance Boot’s Swiss headquarters for tax purposes. Walgreen’s stock fell 12%.
Returns haven’t been much better for Macro Funds. These are the hedge funds that make bets on trends in financial markets, currencies, or commodities. According to The Wall Street Journal many macro funds have been unable to anticipate the twists and turns of the global markets this summer. For most of the year macro managers complained that there wasn’t enough volatility in the markets to put on profitable trades. The market was too listless. When the volatility finally arrived, the models and intellect of many a macro manager failed. The Journal reports:
Graham Capital Management LP has laid off more than 10% of its staff, or more than 20 employees, according to people close to the matter. Six funds at the firm, run by Kenneth Tropin, have posted declines of as much as 5.9% this year, the people said.
Rubicon Fund Management LLP's Rubicon Global Fund Ltd., an $850 million macro fund run by Paul Brewer, the firm's founding partner, dropped 21% this year through July 25, investors said. The fund lost more than 1% in July, the investors said. A Rubicon spokesman said the fund has a strong long-term performance and was up over 18% last year. He declined to comment further.
Meanwhile, a big fund run by investor Louis Bacon lost more ground in July, adding to an already disappointing year, investors said.
Yesterday I suggested that institutional investors ought to dig out the quantitative report by Nomura that makes a convincing long-term case against alternative investments and hedge funds in particular. Today, I’m suggesting that investment staff better be prepared to answer questions. The trustees are going to be armed with a lot of short-term anecdotal evidence against hedge funds.