SVM Asset Management’,’s Colin McLean believes that many hedge fund managers have dodged the fall-out from the subprime crisis from which some are profiting handsomely. He predicts changes to stock lending will have a bigger impact on hedge funds than the liquidity squeeze.
IF not exactly smelling of roses, the hedge fund industry has emerged in remarkably fine fettle from the continuing subprime related crisis, according to Colin McLean, co-founder and managing director of SVM Asset Management.
McLean, whose firm runs two hedge funds, the €20 million Highlander Fund and the €7m Saltire fund, highlights the recent performance of Laxey Partners’ Value Catalyst Fund (in which McLean’s £250 million SVM Global Fund, an investment trust, owns a stake), as an example of how the sector has washed its face despite, or in some cases because of, all the market turmoil seen in 2007.
The Value Catalyst Fund has returned an annualised 16% since it launched in 2000 and with a relatively low exposure to equities was running virtually flat during last August’a correction.
He also says John Horseman’s Horseman Global Fund, in which SVM Global also has a significant holding, has also emerged from the turbulent summer and autumn with flying colours. “John Horseman is up a similar amount to us this year – he’s done well,” says McLean.
McLean’s own hedge funds have also done well this year. Highlander, a long/short pan-European equity fund launched in 1999, is up 30% in the year to mid November, while Saltire, a long/short UK equity fund launched in 2002, is up by the same amount.
Success secrets
McLean, who was born in Maracaibo, Venezuela, but grew up in Scotland, says the secret of this success is prescience. Essentially, he claims to have seen the subprime crisis coming, which enabled him to successfully short stocks in the sectors that would be most effected — including banks, general financials and property developers. “We got a lot of the stock picking right on the short side,” says McLean.
However, McLean points out that some hedge funds have been able to make even more stupendous gains, often by shorting subprime loans themselves. He says this explains why John Paulson’s Paulson Credit Opportunities fund (up 550.8% to the end of October) and Santa Monica-based Lahde Capital’s US Residential Real Estate Hedge V Class (up 1000% to end November) have put in such an electrifying performance this year.
McLean believes that plenty of funds-of-hedge funds products will have turned in respectable numbers themselves, merely by having some exposure to such vehicles.
Earning his stripes
McLean, a former managing director of Franklin Templeton’s European operations, earned his investment stripes as an ‘enfant terrible’ of the fund management industry during the 1990s. This was largely through his role as an activist investor targeting the somewhat stuffy world of closed-ended funds and investment trusts.
He co-founded Scottish Value Management with his wife Margaret Lawson and former Ivory & Sime executive Donald Robertson in 1990. The fund management group was an early convert to the joys of short-selling, something it started doing in 1992.
It has not all been plain sailing for McLean. The Highlander fund reached an impressive €500 million in assets in 2002 but much of this money melted away following redemptions in 2002-03. On the back of a recent strong return to form at the fund, McLean is confident a fresh batch of more sticky investors can be persuaded to put some money back the fund.
“There’s a lot of hot money in the hedge funds sector and this is one of its problems,” admits McLean. He cites John Armitage’s Egerton Capital and Lansdowne Partners as examples of hedge fund groups that have broken the mould and built greater loyalty among their investors.
Sound advice
McLean does not think hedge funds, particularly those run by small boutiques such as his own, should be chasing money from institutions such as pension funds. He says these sort of investors can have very pernickety requirements and their reliance on intermediaries such as Mercer and Watson Wyatt further complicates matters.
Instead, he believes it makes more sense for hedge funds to target money from family offices, long-term wealth managers and funds of hedge funds. “They generally understand the hedge funds universe better than the institutions.”
He says that 130/30 funds — an area into which many of the conventional asset management houses are now straying — are better suited to the needs of institutional investors such as pension funds, partly because they sit more comfortably within larger fund management houses that are geared up to handle the exigencies of fastidious consultants. “Those are much closer to pension funds’ comfort zone. They are also something they can move into quite easily from an existing long benchmark.”
Misleading metrics
McLean believes that the turbulence of the markets since July 2007 has really tested some of the quantitative (“quant”) systems that are used by many hedge funds, partly because the underlying metrics and assumptions were rong.
“Prices have been driven by a need for liquidity and have not necessarily been reflecting the underlying value or risk. There’s an assumption among quant models that prices ultimately reflect value, but there are times when prices can depart quite radically from true values.”
The subprime crisis has also meant that some of the approaches favoured by long-only managers have broken down. “Who would have imagined that the yield from bank shares would widen out beyond 6% or 7%? Also there’s a lack of trust in the numbers. Until we’ve gone through a lot more company reporting, the market just doesn’t believe the numbers.”
Overall, McLean is more concerned about the 2007 performance of many long-only vehicles than he is about the effect of the crisis on hedge funds. He says that the worst offenders among long-only funds have been index trackers which have “locked people into a downward spiral on bank exposure”.
He points out that a number of high-profile, long-only managers have had an appalling time during 2007, as have many of the UK’s equity-income funds, partly because of their enduring faith in some of the worst hit sectors, including banks, general financial and consumer cyclicals.
He warns that an end to the subprime crisis is still some way off, and is quite bearish about the near-term outlook for the UK and US economies. “I think it will spread out a bit more and undoubtedly western economies will slow down, so we’ll see quite a sharp fall off in consumer confidence in the UK and we’re already seeing that in the US.
Looming changes
Even so, McLean believes the fallout from the subprime crisis will be less of an issue for the hedge fund industry than imminent changes to the securities-lending supply chain.
He says regulators in Ireland and Luxembourg are demanding that, under UCITS III regulations, when 130/30 funds sell shares short these must be physically covered by assets that are held by the custodian bank.
Given the expected $2 trillion scale of the 130/30 sector by 2012, McLean warns this could have major ramifications on the supply side of the hedge fund industry. “I think we could see disintermediation, with prime brokers finding themselves out of the equation and funds borrowing securities direct from the custodian. One of the effects will be lower fees for stock borrowers.”
A recent book on the investment industry published by investment consultants Mercer described the hedge fund industry as being equivalent to having about 8,000 planes in the air but with only 100 good pilots. McLean is less concerned than Mercer about the skills within the sector. However, he does believe that many hedge funds are over-leveraged.
“There are far too many hedge funds with leverage of 200% to 300%. I think leverage of above 200% is quite risky, even if your stock-picking is good and even if you are not particularly market sensitive. Too many hedge funds seem to be reliant on the ability of their modeling to remove individual factor risks. But that can quite easily break down.”
“In some parts of the industry there is also too much faith in quant models, overlays and balancing factors. I don’t think that faith is really merited.”
He points to the Bear Stearns High-Grade Structured Credit Fund which, when it had to be bailed out in June 2007, effectively ushered in the credit crunch. “That fund had had 40 successive positive months before it was wiped out.”
“It’s possible for really smart people with a good brand name behind them to really mess up. But to me the interesting thing is not that such funds have blown up, it’s that there wasn’t an awful lot of indication beforehand.”
As far as the hedge fund universe, it remains to be seen how many of those 8,000 planes are going to explode in mid-air or crash land. McLean says: “If the market does go lower than here, as I expect it will, then a lot [of hedge funds] will find it hard to unwind their gross and sort of unwind their market exposure and we’ll see some of those long/short funds just correlating with the market and just unwinding their gross.
“I think we’ll see some of the long/short funds just correlating with the market and worrying people about where they might go next.” However he says he has not detected any widespread fear or panic across the hedge fund industry — or anything that is driving investors back into conventional funds or even to move out of the hedge funds that they own.
“We’re at a point where we haven’t really seen all the results.”
McLean does predict however that some of the under-performers are going to experience some rather big outflows.
He also says that a lot of funds-of-hedge funds have held up over the second half of the year, especially if they’ve had some exposure to Paulson & Co’s funds or other funds that had the foresight to short-sell subprime loans, financials or housebuilding and property companies.
However, McLean concedes that the full extent of redemptions from the hedge fund sector will not become apparent until after the year end. This is partly because investors in some of the worst performing hedge funds such as Florian Homm’s Absolute Capital funds are effectively being “held hostage”.
This article was published in the Winter 2007 issue of European Fund Manager (EFM)