From the January 01, 2008 issue of Futures Magazine • Subscribe!

Whatever happened to diversification?

Never has a financial disaster unfolded in such an excruciatingly slow-motion fashion as the subprime debacle and resulting credit liquidity crisis. It was mid-July when several hedge funds either felt the pain of re-pricings in the mortgaged backed securities and collateralized debt obligation (CDO) market or were affected by the resultant credit crunch, but it wasn’t until several months later when investment banks started reporting huge write downs in third quarter performance when the scope of the disaster began to take form. And most analysts we talk to say there is still a lot to unfold before we see the true picture.

While the specific problem was subprime, particularly for the Bear Stearns hedge funds that went bust, the resultant credit crunch affected more markets and managers. “If we are looking at August in terms of the extreme events, it wasn’t so much everyone had this subprime exposure, it was that everybody was having to deliver and get liquid and that started to affect commodity markets, equity markets, etc.,” says Rian Akey, head of research for Cole Partners Asset Management. Akey, who started seeing the popularity of these structured products rise in 2004, believes the market will take a close look at risk. “There is going to continue to be an appetite for that kind of risk, whether it is subprime or equity market exposure, or whether it is exposure to China or emerging markets in general, [but] the next time around when people are looking at CDOs or looking at these kinds of structured products they are going to be a little bit more aware of what the true return profile potential is. Anything that is non-exchange traded, you are going to see a little more focus on valuation,” Akey adds.

A spokesperson for Horizon Cash Management points out there has been a disturbing tendency by certain high-yield bond funds to use the word “cash” in their description. Horizon had no exposure to any of the questionable securities involved in subprime but noticed the tendency of such products to be used as a form of cash. “The cash that we are entrusted with we view as the most essential, fundamental, protectable part of one’s portfolio. This is not to be put as a wild investment. This is to provide the bedrock against which those eventual investments could be made by the fund manager in accordance to his or her strategy. This is meant to be cash, the most safe and sound investment,” says the spokesperson.

Sowood Capital was a hedge fund that lost more than 50% of its assets in a couple of weeks in July and eventually sold its assets to hedge fund giant Citadel. In a letter to investors, Sowood said it wasn’t necessarily direct exposure to subprime that caused the problem but a downgrade in their collateral. While we can’t assume they were typical, it does illustrate how this began to snowball because these products, which were mispriced, were used as collateral for other investments. “Absolutely, people bought them and then used them as collateral for further loans, to do more business, and the hair cuts on those have gotten to be substantial. Right now, I don’t think a lot of people accept that stuff as collateral any longer,” says Bob von Halle, managing partner at Horizon.

Von Halle says that that a fund of funds with a 20% exposure to subprime, if it used that as collateral could face greater risk in the remainder of its portfolio. The pain caused by the rapid decline of the value of that 20% would cause them to liquidate other strategies to bailout the problem that was created in the subprime, and the losses would have a far greater impact on the overall portfolio, he says.

He adds, “That goes in the category that you sell what you can, not what you want to [sell].”

Modern portfolio theory holds that by being diversified in multiple non-correlated asset classes a portfolio stands a better chance of avoiding financial ruin. If the collateral that is backing such investments is not stable and extremely liquid, it would seem that would negate some of the effects of diversification. Prav Sambamurti, senior manager at Ssaris advisors, agrees. “There were other asset managers, even mutual funds, that had exposure to this indirectly because there were some enhanced cash funds that were invested in these things, so mutual funds with excess on hand may put it into these cash funds that are supposed to be making 25-50 basis points over Libor but they are taking these excessive risks.” Ssaris had no exposure to this. “Collateral management is a critical aspect of asset management, so we vet any of the cash management vehicles that these guys would be investing in,” Sambamurti says. He does see the subprime crisis being a boon for managed futures though. “When volatility comes into the marketplace, that is usually good for people like us,” he says. “A lot of the guys on Wall Street have been taught since school that markets are efficient all of the time that trends shouldn’t exist and breakouts happen only by chance. They are skeptical about what we do.That being said, [Ssaris] has made a living at this for 30 plus years,” Sambamurti says.

Managed futures have been around for a long time but have taken a back seat to more sexy strategies. However, their ability to diversify a portfolio and daily mark to market attributes make them the best choice in alternative investments.

MF Global settles

MF Global, formerly Man Financial, has reached an agreement with the receiver for bankrupt hedge fund Philadelphia Alternative Asset Management (PAAM) and related entities to pay $69 million into a restoration fund for the benefit of PAAM investors plus an additional $6 million in legal fees. The receiver had sued Man Financial, who agreed to the settlement without admitting or denying wrongdoing.

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