Globaltrader has a nice analysis on this item from the Financial Times but I thought it so important, I’ll reprint it here as well:
Europe’s largest hedge fund admits flaws
GLG Partners, Europe’s largest hedge fund manager, has admitted that flaws in its trading models were partly to blame for a 14.5 per cent drop last month in the value of its Credit Fund.
In particular, it has acknowledged that the mathematical model it used to price complex credit derivative products failed to foresee market swings after last month’s ratings downgrades of General Motors and Ford.
In a private letter to investors, a copy of which has been obtained by the Financial Times, the hedge fund argues that it has now rejigged these trading models. The admission is significant because other banks and hedge funds appear to have been using similar trading models, meaning that they may also have suffered big derivatives losses.
GLG warns that conditions in the credit market could remain difficult for some time because banks and hedge funds are trying to get out of loss-making derivatives positions at the same time.
“Segments of the hedge fund community and a substantial number of investment banks are nursing material losses in structured credit trades as a result of recent market conditions,” the letter says.
GLG has 15 other funds, which have not suffered heavy losses. The damage to the Credit Fund, which trades products related to corporate bonds and convertible instruments, arose in part because the fund incorrectly predicted how vehicle makers’ debt would react to the GM and Ford downgrades.
However, GLG also failed to anticipate a sharp drop in the price of risky tranches of collateralised debt obligations. These are bundles of debt instruments.
The GLG model implied that the type of price swing that occurred last month was so unlikely that it was a so-called “eight standard deviation move”, an event so rare it could be generally ignored.
This is in spite of the fact that GM’s downgrade was widely anticipated and policymakers have repeatedly warned that a market jolt could cause liquidity in the CDO market to dry up.
GLG blamed the model’s shortcoming on the fact that this CDO market had only traded since last year, and that “consequently any risk simulations based on historic data would not have identified this move”. However, some observers argue that the episode shows the dangers of relying excessively on models.
Many bankers argue that a recovery is now under way in CDO prices, which may help to ease the pain for hedge funds. Guy Cornelius, head of European fixed income at UBS, said: “Market nerves have calmed [in CDO trading].”
However, the real impact of May’s credit price swings on the sector has yet to emerge, since it remains unclear whether investors are withdrawing money from hedge funds.
I’ve talked about the problem of negative derivative events when the Fed changes interest rate policy. The problem with many of the new hedge funds are that their models are basically trend following in nature, even though most hedge fund managers don’t know it – not even the geniuses at Long Term Capital management knew that they were just riding a bull market in bonds. Trends can last for decades but once the trend on which the model was built has reversed, these types of problems start appearing.
The other major negative issue is that in order to attract money, many new hedge funds have shortened the lock up for investors. Therefore, just as fast as the money poured into the "hot" fund, it will get sucked out again if the returns aren’t up to par (I would guess that a -14% return for the month is not what GLG investors had expected). That will cause continued volatility, the likes of which we saw in March and April when "unexpected" events such as the GM implosion ocurred. Many of the instruments which these hedge funds trade are extremely illiquid and when the positions are unwound, they cause irregular stress on the rest of the financial markets.
In summary, if this is indeed the only blow up in the hedge fund world, then the markets held in extremely well and should be set to move higher. However, if the Fed continues to raise rates and place pressure on these hedge fund models that aren’t stress tested, it’s going to be a bumpy and uncomfortable ride.