The hedge fund industry may witness the collapse of a fund this year, similar to the implosion of Long-Term Capital Management LP in 1998, because of inadequate risk measures and as managers put on aggressive wagers, according to Gravitas, a New York-based firm that provides systems and consulting services to alternative investment firms.
“Recent mediocre performance may compel some managers to take greater risks,” Jayesh Punater, chief executive officer of Gravitas, said in a Jan. 5 telephone interview. “And combined with the fact that many funds still have poor risk controls, both operational and market-risk, we could see a blow up like LTCM.”
Long-Term Capital, run by John Meriwether, roiled global markets when it lost more than 90 percent of its $4.8 billion of assets in the weeks following Russia’s currency devaluation and bond default in 1998.
Since LTCM’s collapse and the onset of the global financial crisis in 2008 and 2009, hedge funds have focused on increasing their risk measures and leverage is currently lower, according to some consultants and academics.
“What’s being required is external third party evaluations, documentation of valuations policies,” said Ellen Schubert, independent senior adviser to consultant Deloitte LP’s asset-management services practice. “Being able to measure your risk and value your portfolio has been the focus of these funds over the last few years. If there’s somebody who has poor risk processes, then investors aren’t going there.”
The chance hedge funds might blow up will always be true, according to Lasse Pedersen, a professor of finance and alternative investments at NYU's Stern School of Business.
“There’s certainly risk and there can be blowups in hedge funds that are doing leveraged strategies in illiquid markets,” he said. “You can’t really take risk without there being some chance of that not going well.
Punater said many large funds still rely on excel spreadsheets to manage most of their data. He said he doesn’t expect there to be any systemic risk tied to the hedge fund collapse following government measures to curb risk in financial markets after the bankruptcy of investment bank Lehman Brothers Holdings Inc.
Punater said that he also expects a hedge fund to reach $100 billion in assets this year because of consolidation and investors continuing to allocate to the largest managers.
“The world-class funds out there with strong infrastructure will continue to attract the majority of money,” he said.
About 75 percent of the $19 billion of net deposits in the industry in the third quarter went to managers overseeing $5 billion or more, according to Chicago-based Hedge Fund Research Inc.
Punater in 1996 started Gravitas, whose clients include hedge funds, fund of funds and private equity firms.