From Barron's:
Talk to Andrew Silton for five minutes about
hedge funds and you may want to sell every one you have. The retired
chief investment advisor of North Carolina's pension plan thinks many
funds will be in for a world of hurt once interest rates rise. And with
the Federal Reserve winding down its bond-buying program, he thinks that
rate spike is coming soon. "Hedge strategies that work 90% of the time
could have serious problems," he says.
The
structure of hedge funds presents unique challenges. Because hedge fund
fees -- typically 2% of assets and 20% of profits -- are so high,
managers often employ leverage to juice returns. This amplifies the
exposure to rate-sensitive securities, and also creates a cost structure
that increases along with rates -- they're borrowing at higher rates --
when their portfolios could be the most vulnerable. For this reason,
Silton, in his Meditations on Money Management blog, has urged his
fellow pension managers to rethink their hedge-fund positions.
Not
only does the cost of leverage increase with rates, but the amount of
collateral brokers demand from funds increases, as well. That forces
fund managers to sell off their portfolios to reduce their leverage and
meet margin calls. In a falling market, the end result could be a
snowball effect for their most illiquid stocks and bonds.
Ironically,
Silton thinks the hedge funds most vulnerable to a rate shock today are
those designed to avoid it. Many fixed-income hedge funds buy
high-yield bonds and short Treasury bonds as a defense against rising
rates -- historically, the higher yields on junk bonds provide enough of
a cushion to withstand rate increases. In 2009, for instance, junk
yields got as high as 20%, while Treasuries paid almost nothing. No
interest-rate increase will damage a 20-point yield spread. But today,
high-yield bonds pay less than four percentage points more than
Treasuries—a tight spread that will probably blow out if rates rise. For
one, yield-hungry investors will start to view Treasuries as more
attractive relative to other bonds. Two, default levels for junk bonds
could increase as overleveraged issuers refinance at higher rates,
putting pressure on the sector. Meanwhile, hedge funds will face margin
calls from their brokers, higher financing costs, nervous investors, and
the challenge of selling illiquid junk bonds in a falling market.
Some
hedge-fund experts are already lightening up on their bond-fund
exposure. "We have probably the lowest weighting in credit hedge funds
in years," says Dan Elsberry, senior managing director of K2 Advisors, a
subsidiary of Franklin Templeton that has more than $10 billion
invested in hedge funds. "As rates pick up, it will be much better on
the long-short equity side than the credit side." ...
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