Hedge Funds Cut Risk, Wait for Opportunities

Hedge Funds Cut Risk, Wait for Opportunities

By CASSELL BRYAN-LOW
April 17, 2008; Page C1

LONDON -- In the risk-driven world of hedge funds, managers are moving into the safe haven of cash.
Hedge funds typically aim to put almost all of their clients' money to work in stocks, bonds and other investments, often adding borrowed funds to magnify their gains. Lately, though, as markets have gyrated in unpredictable ways, they have been setting aside a lot more money in cash and similar investments. In doing so, they are effectively forgoing potential returns for the assurance of liquidity.
Managers and analysts offer various reasons for this change. For one, the risk of sudden cash demands has risen, as banks require extra collateral against loans and more investors pull their money out of hedge funds. Also, borrowing money has become difficult and expensive, with financing costs for some funds rising two times or more.
Beyond that, some fund managers are building up cash hoards so they will be able to pounce on opportunities to buy beaten-down assets, such as corporate loans or mortgage bonds.
"There are definitely opportunities," says Joachim Gottschalk, chief executive of Gottex Fund Management Holdings Ltd., a Swiss fund of hedge funds that has about $16 billion in assets. "But we have to be careful for timing." He says Gottex has built up its cash position to 10% in its largest fund, from zero about a year ago, and it is closely watching the markets for bank loans and asset-backed lending for signs of a bottom.
Hedge funds don't publicly provide information on the amount of cash they hold, and even information for investors can sometimes be scant. One rough indicator -- "total free credit," or clients' remaining margin-credit lines at brokerage firms minus the amount of credit they already have used -- has risen sharply in recent months, says Mary Ann Bartels, an analyst at Merrill Lynch & Co. in New York. In February, the New York Stock Exchange reported total free credit of $65 billion and in January it stood at more than $90 billion. That compares with a negative $44 billion a year ago. Ms. Bartels assumes that the heaviest users of margin credit are hedge funds.
While cash levels tend to vary depending on a hedge fund's investment strategy, industry specialists say they have increased at most types of funds.
Cash at some funds that focus on stocks is about double what it has been historically, says Gunner Burkhart, head of prime-brokerage services for Europe and the Middle East at Lehman Brothers Holdings Inc. And prime brokers, which provide services to hedge funds, say some funds that invest in credit markets or global-macro strategies -- making bets on global financial and economic trends -- have increased their cash holdings by two or three times, or to as much as 40% of assets under management.
At London-based GLG Partners Inc., one of Europe's largest hedge funds, managers of some "long-only" funds -- which bet solely on rising asset prices, as opposed to funds that also take "short" positions designed to profit from price drops -- were holding about 10% to 15% of assets in cash as of the end of last month, compared with about 5% under more normal market conditions. Overall, GLG manages about $25 billion.
Some managers, of course, are still fully invested in the markets. Hedge-fund clients, who pay hefty fees to benefit from managers' investing talent, don't usually see holding cash as the best use of their money. "The downside of them sitting on the cash is that they are potentially missing out on investment opportunities," Lehman's Mr. Burkhart says.
Given the current turmoil in markets, though, some investors, including the "fund-of-fund" groups that invest in pools of hedge funds on behalf of institutions and wealthy individuals, say they don't mind seeing fund managers taking a careful approach.
"We'd rather that than they have unnecessary large losses," says Richard Blake, a London-based senior portfolio manager at Comas, Commerzbank AG's roughly $1.4 billion fund-of-hedge-funds business. Mr. Blake says the level of borrowing -- or leverage -- in use among the hedge funds in which Comas's flagship fund, CGAL, invests has roughly halved since the middle of last year. In aggregate, the underlying hedge funds add about $50 to $100 in borrowed funds for every $100 invested by clients, compared with about $250 for every $100 in July.
Stephen Decani, a senior partner at London-based Arch Financial Products LLP, which manages about $1.6 billion of assets and focuses on lending to infrastructure, shipping and other projects, says he has added to his cash position in part to give investors "a level of comfort."
"We are in a cautionary mode," he says.
Hedge funds' increased holdings of cash also come as the industry braces for waves of investor withdrawals over coming months on the heels of a quarter in which hedge funds, on average, performed dismally. Hedge funds as a group were down 2.8% for the first quarter of this year, according to Hedge Fund Research of Chicago, and many individual hedge funds have performed much worse.
Some even expect to see investors pull more money out than they put in -- the first time the hedge-fund industry has seen a quarterly net outflow since the fourth quarter of 2005.