As another hedge fund nearly collapses, we explain the hazards baked into these funds.
Last week, the FT Alphaville column reported some extraordinary news about a hedge fund investing solely in commodities.
Here's a table of returns for 2009 from the Ebullio Commodity Fund, managed by Essex-based Ebullio Capital Management:
| Month | Return (%) |
|---|
| Jan 09 | -1.2 |
| Feb 09 | 4.8 |
| Mar 09 | 2.1 |
| Apr 09 | 4.5 |
| May 09 | 2.9 |
| Jun 09 | 1.7 |
| Jul 09 | 3.1 |
| Aug 09 | -3.0 |
| Sep 09 | 8.0 |
| Oct 09 | 1.6 |
| Nov 09 | -7.7 |
| Dec 09 | 10.3 |
| 2009 | 29.3 |
As you can see, Ebullio enjoyed some decent (if volatile) monthly returns, ranging from -7.7% in November to +10.3% in December. Overall, the average monthly return in 2009 was 2.2%, for a total yearly return of 29.3%. Then again, against a backdrop of a massive bounce-back in commodity and asset prices in 2009, these returns are fairly modest.
Even so, Ebullio's performance in 2008 was even more impressive, with a return of 91.9%. So, with a two-year gain of over 148%, Ebullio investors must be laughing, right? In fact, they're much more likely to be sobbing. Here's why...
What happened next?
Now brace yourself, because here are Ebullio's returns for the first two months of 2010:
| Month | Return (%) |
|---|
| Jan 10 | -69.7 |
| Feb 10 | -86.3 |
In just two months, the fund's value collapsed by a total of 95.8%, leaving investors with just over 4p for every pound invested at the start of the year.
The minimum investment in Ebullio is $100,000. Had you invested this sum in the fund at the start of 2008, it would have grown to over $248,000 by the end of 2009.
So far, so good. Alas, after disastrous returns in January and February, you'd be left with just over $10,000, for an aggregate loss of 89.6%.
What a horror story. To all intents and purposes, Ebullio is a total wipe-out -- what I call a PCL, or permanent capital loss.
What went wrong?
What blew up Ebullio? This month's letter to investors explains all. It seems that the fund's manager had built up huge, leveraged positions in copper, nickel and tin. Indeed, Reuters reported last November that Ebullio held almost 90% of tin stocks and cash contracts at the London Metal Exchange.
When China announced tightening measures in January, metals prices tumbled. Having cornered 90% of the LME tin market, Ebullio was the market. Therefore, it was forced to liquidate its positions and, in doing so, sustained massive losses. In effect, the fund became a giant bet on rising non-ferrous metals prices -- and one which failed spectacularly.
The root of the problem
In common with other hedge funds, Ebullio operates a '2+20' fee structure. It takes 2% of assets under management, plus 20% of yearly gains above a certain watershed.
As I warned in The Monstrous Maths Of Hedge Funds, this set-up creates a huge moral hazard for hedge-fund managers. Rather than make do with modest monthly returns (and management fees), there is a great incentive for hedge funds to gear up, adding massive leverage in order to boost their returns.
Of course, the key problem with all this extra leverage is that it adds much greater risk, in the form of heightened sensitivity to liquidity and losses. In short, when hedge funds fail, they usually fail spectacularly.
This is because, unlike everyday investors who avoid leverage, hedge funds are at the mercy of what's known as a 'liquidation spiral'. When hedgies become forced sellers, liquidating large leveraged positions can trigger falls in the underlying values of assets up for sale. In turn, these trigger further margin calls from lenders, leading to yet more sales, steeper falls, and so on until the fund collapses.
As investors in giant hedge fund Long Term Capital Management (LTCM) will tell you, this kind of approach is akin to 'picking up pennies in front of a steamroller', a phrase coined by Nicholas Nassim Taleb.
Using gigantic levels of leverage, LTCM magnified tiny mis-pricings in bond markets into yearly gains of around 40%. However, LTCM imploded spectacularly in 1998, following a liquidity squeeze that saw the fund lose hundreds of millions of dollars a day until it was bailed out and unwound by a consortium of Wall Street's finest.
What's the lesson?
The obvious answer to the problem of forced liquidations is to reduce leverage and increase liquidity (by holding more cash and other cash-like instruments in reserve). However, while reduced leverage reduces the risk of outright failure, it also drags down hedge fund managers' earnings.
This fundamental asymmetry (and conflict of interest) between investors and managers is the main reason why I have never been tempted to invest in hedge funds. In addition, hedgies seem to ignore or misprice the long-tail risks which can cause fund blow-ups.
As for the remaining investors in Ebullio (Latin for "to produce in abundance"), they have zero chance of ever seeing their capital being returned. Given that the fund is now 1/25th of its previous size, even chunky monthly returns will do little to restore former value. What's more, life is sure to be tough for Ebullio's managers, with assets under management of just $1.5m. Oops.
More from Cliff D'Arcy:
> Time is running out if you want to use your tax-free ISA allowance for 2009/10. And remember, if you're 50 or over, your limit has now been increased to £10,200. Protect your investments from the taxman with a Motley Fool Self Select ISA.
