Six years on, evidence of the immense distress in asset prices resulting from the 2008 financial crisis are difficult to find. Today most markets have fully recovered their losses and are now again teetering on frothy. With the S&P PE ratio now close to 19x,1 and with high-yield spreads now at just 334 bps,2 it’s hard to tell which part of the capital structure is more fully-valued. Market liquidity premium, the premium investors receive for taking on liquidity risk, appears to be near all-time lows based on a variety of measures recently outlined in the Bank of England’s Financial Stability Report.3 Hedges have mostly been costly to hold, and investor demand for ‘tail risk funds’ has all but disappeared.
Underneath the tranquil veneer, market structure has clearly been altered since the crisis. “Too big to fail” was too much to bear and the subsequent series of financial reforms which were spurred on by the crisis continue to have a lasting effect on markets. A combination of the Dodd Frank Act and Basel III have systematically dismantled most proprietary trading activity in investment banks, led to a drastic reduction in bank risk appetite, and as a result have fundamentally changed banks’ roles in market functionality.4 Market-making functionality has continued, but the depth of liquidity provided by banks has been significantly curtailed. According to Fed data, fixed-income inventory on bank balance sheets is now 70% lower than 2007 levels.5 While this has made the business of investment banking somewhat duller, it has created many exciting opportunities for hedge funds, as well as new risks for financial markets.
The Talent Diaspora: Please Turn Off the Lights When You Leave
One of the first opportunities that the hedge fund industry capitalized on in the wake of the new post-crisis financial reforms was the subsequent mass exodus of investing and trading talent from prop desks. The “Volker Rule” was enacted as part of the Dodd Frank legislation and in effect outlawed proprietary desks within investment banks. New and tougher capital charge requirements as a result of Basel III further restricted proprietary risk taking in the context of customer facing flow desks. As a result, entire prop teams were subsequently “Volkered,” and many flow desk traders also left as the risk appetite within banks was reduced.
Hedge funds and hedge fund investors benefited from this diaspora of talent from the sell-side as former prop traders joined existing hedge fund firms or started new hedge funds. As always, careful manager selection was still critical during this period as many traders struggled to transition successfully from the sell-side to the buy-side. For some, this transition was difficult for a number of reasons. No longer working within investment banks, these traders lost the greater access to investor flow information on the sell-side and the ability to more easily give back capital on a prop desk when the opportunity set is low. In addition, these traders now faced the added challenges that exist on the buy-side, including raising money, running a business, and servicing clients.
Not only were hedge fund investors able to access a new pool of talent as a result of the Volker Rule, but the large increase in new hedge fund starts enabled hedge fund investors to push back on terms. As a result, hedge fund fees were lowered industry-wide and investors pushed back on lock-ups, side-pockets, fund governance policy, and other key investor control mechanisms. Also, deep discounting for early investing became more widely utilized by the industry as ‘founders fee’ discounts became a popular market convention for raising capital for new funds.
Risk Displacement: Leaving Risk Taking to the Buy-Side
The “Volkered” diaspora effect gained steam in the years following the crisis as traders’ stock compensation vested, investor appetite for hedge funds grew post the crisis, and the Volker Rule took effect. Today, however, high profile prop desk spinouts are becoming exceedingly rare as the desks have mostly all spun out. However, hedge funds have continued to benefit from the effect of the financial regulations by employing a variety of trading strategies that the banks have been forced to discard.
Prior to the crisis, banks were the kings of arbitrage strategies. Banks benefited from having the best information flow as their customer facing role enabled them to know who was buying what at any given time. They also benefited from the lowest cost of capital as their transaction costs were lower and their high capital structure leverage ratios provided an ample source of risk capital. Banks could also attract marquee trading talent, as the combination of superior information flow and low cost of capital led to an abundance of lucrative opportunities for savvy traders to exploit. As a result, most arbitrage and arbitrage-like strategies were dominated by bank prop desks.
In today’s post-Volker Rule world, sell-side desks typically need to have matching orders when taking on customer flows. They can rarely hold inventory more than a few hours and, when they do so, it is exceedingly costly. As a result, a large number of trading strategies, ranging from the simple inventory warehousing of municipal bonds to the complex arbitraging of futures versus bonds, have become viable and valuable for hedge funds. Not only are these strategies lucrative for hedge funds, but their return profile generally does not rely on market direction. As risk premia in global risk assets has compressed to pre-crisis levels, having access to uncorrelated sources of returns has become ever more critical to hedge funds and their investors.
Impact on Risk-Adjusted Returns
While the gutting of prop activity in banks has in large part improved the return prospects for hedge funds, it has also created new risks for financial markets. Though hedge funds have stepped in to fulfill a liquidity-providing role in many markets, they are more selective in the securities they are willing to hold, they reserve the right to step away from markets at any time, and their capacity for buffering liquidity is a small shadow of what the highly-leveraged investment banks could muster prior to the crisis.
Last summer we saw evidence of just how thin some seemingly large markets could become in times of stress. For example, during May and June of 2013 when municipal and emerging market debt funds were experiencing large investor outflows, liquidity largely evaporated. Moving even 10 or 15 million in muni bonds on a Friday afternoon was only possible with extraordinarily steep discounts. The dismantling of risk appetite on the sell-side has created a new kind of gap risk in many markets. The absence of traditional liquidity buffers could lead to temporary, but substantial supply-and-demand imbalances and create unexpectedly large moves in price and volatility.
As Always, Prudence is Required When Engaging Investment Opportunity
The implication for hedge fund investors is that the financial reforms are changing the risk and return landscape for many hedge fund strategies. The reduction of prop desks and risk appetite at banks means lower competition for both talent and investment opportunities for hedge funds. However, a reduction in liquidity buffers in many markets, especially in credit markets, requires that investors approach these opportunities carefully and with full cognizance of how thin many of these markets may become in times of stress. Sensible hedges, and careful strategy and manager selection, are key attributes of a successful approach to tapping these lucrative opportunities.
1 S&P PE Ratio (TTM). Wall Street Journal (August 5, 2014).
2 CDX HY spread mid. JPM data query (August 4, 2014).
4 Third Basel Accord (“Basel III”); Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”)
5 Government Securities Dealer Statistics Unit, Federal Reserve Bank of New York,http://www.newyorkfed.org/markets/primarydealers.html
Sam Diedrich, CFA, CQF is Director and Sector Specialist for the Fixed Income Relative Value strategy at Pacific Alternative Asset Management Company (PAAMCO).
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