Chapter 5

2008—The Year Hedge Funds Broke Their Promise to Investors

The events of 2008 will be burnished in the collective memories of investors probably for the rest of our lives. I began my career in 1980 at the London Stock Exchange before moving to New York in 1982. In 1987 I was trading interest rate derivatives for Manufacturers Hanover Trust (a name long forgotten as it’s now part of JPMorgan). Trading on Monday, October 19 and in subsequent days is an experience I’ll never forget. All the mathematical links that connected the prices of securities, futures, and swaps were stretched beyond all recognition. We watched with morbid fascination that day as stock prices sank and then collapsed, wiping out more than 20 percent of the market’s value in just a few hours. Slowly at first but then with increasing speed, bond prices reversed their decline as the bear market abruptly ended. A rising trade deficit and depreciating U.S. dollar had been driving down Treasury bond prices for months, but the economy had remained strong and stock prices had been rising most of the year. The new Fed chairman Alan Greenspan had begun raising rates that Summer to establish his inflation fighting credentials in following inflation’s conqueror Paul Volcker. The falling U.S. dollar, falling bonds, and rising stocks—the markets had been feeding off one another in a familiar dance.

During the late afternoon of that extraordinary Monday and into the Tokyo session that night, bond prices began to rise (i.e., interest rates began falling) as the markets contemplated an economic slowdown or even a recession induced by the sudden loss of wealth caused by the stock market crash. Incidentally, that evening following the 508 point drop in the Dow Jones Industrial Average, I solemnly warned my wife that we should start accumulating stores of canned food in preparation for the coming Depression. Television footage of soup lines from the 1930s that followed the 1929 stock market crash were already playing on the nightly news. History was surely going to repeat. My wife, who was grounded in the real world and was thankfully not of Wall Street, breezily replied that regardless of what had happened on Wall Street, Main Street didn’t care. Life would not change, she asserted. It was simply a problem for “you traders.” I dismissed her naiveté. The tidal wave was coming to Main Street; it had simply hit Wall Street first. But of course she was right, and gross domestic product (GDP) growth barely stumbled in the months ahead.

Financial Crisis, 1987 Version

For fixed income traders such as me, the following day Tuesday, October 20 was more memorable than the 19th as the sharp turn in bond sentiment translated into breathtaking volatility. At the time I traded Eurodollar futures and interest rate swaps, similar instruments that provided opportunities to arbitrage between the two of them. My trading partner and I arrived at work early that Tuesday morning intending to develop a plan, but the phone lines from brokers were all flashing urgently with trades to be done so we just plunged in and started trading. It seemed as if the whole world needed to buy Treasury bonds and Eurodollar futures, anything that would pay a reliable interest rate. One of my clearest memories is doing a trade that required me to buy Eurodollar futures as a hedge.

Why did I short the market when it seemed as if everybody was already short? We were market makers and I traded with a trader at another bank at a price that reflected utter panic-stricken urgency on his part. I had built in almost 2 percent of cushion on the trade, an enormous spread since at that time arbitrage margins on those types of trade were typically 0.1 percent (10 basis points, or about one twentieth of the spread I’d priced in on this trade). So I called up our broker on the London futures exchange (it was early; U.S. exchanges were not yet open) and following futures prices on the screen while I dialed I watched my expected profit rapidly melt away. Incredibly, the London broker reported “no offers” as he screamed across the exchange floor. Rather than bid into a one-sided market (i.e., one with no offers) I resolved to wait a few minutes until the CME (Chicago Mercantile Exchange) opened the far larger U.S. Eurodollar futures market. I watched with fascinated horror as the March 1988 futures contract, which represented three-month Libor in only five months’ time, rose in price from its close the previous day of 89.20 to trade at 94.00. I can still remember the numbers to this day; it was such a blistering experience. The market went from expecting Libor in March to be 10.8 percent on one day to expecting it to be only 6 percent less than a day later. As my highly profitable trade swung to a large loss, I tried to contemplate just how bad it could get. How much could I lose on what was a relatively small trade? I paused for a few moments, thinking, looking for some firm guideposts that would show where futures “ought” to be. There was nothing; the market had no anchors, nothing was tethered to anything else, bond and futures prices could go anywhere they wanted. The familiar mathematical relationships were shredded. Everything was pure emotion. The bond market was at that time on that day simply a poker game separating the weak hands from their money, handing it to the emotionally stronger.

I waited. Following a buying frenzy futures fell a dizzying 100 points (i.e., a 1 percent jump in interest rates) in about 10 minutes as the buyers briefly vanished. I gratefully covered at a small loss and moved on. There was so much activity, so many trading opportunities, and no time to dwell on that first trade. We plunged in, buying low, selling high, exploiting the market dislocations as we reacted to prices on screens and from brokers with mostly mental arithmetic. There just wasn’t time to input numbers into a computer; they moved too sharply, the result was out of date before the enter key was pressed. Some trades were winners and some were losers, but we kept moving. Doing our type of trading in that market was like playing in the F.A. Cup Final (English football’s rough equivalent to the Super Bowl) except that we’d arrived there without warning. This was our moment—don’t think more than two minutes ahead, just react to the ball.

By the end of the day as we totaled everything up, my partner and I had made a record daily trading profit for our desk. The numbers were laughably small by comparison with today’s trading profits, but we were exhausted and exhilarated. We knew we’d experienced history and a supreme test of our abilities. We were amongst the winners. We were young, and youth can be wonderfully intoxicating in a trader; trading losses rarely hurt, because youthful confidence allows breezy self-forgiveness and a belief that next time will be better. As I got older I became less tolerant of the pain of losing money and less willing to expose myself to financial harm. But those few days in 1987 are permanently burnt in my memory, from a time very early in my trading career. Incidentally, my trading partner back then was Barry Wittlin. Barry is one of the most gifted interest rate traders I’ve ever known. A few years later he joined Merrill Lynch before setting up his own hedge fund in 2007. Barry doesn’t seek the spotlight but is a true intellectual giant, and I have no doubt he is in the process of using his prodigious talent to build himself a fortune and make his wealthy clients wealthier.

How 2008 Redefined Risk

For 20 years following the 1987 Crash I was confident that the world would never experience something quite like that again. Looking back today, no doubt we all wish that our problems had simply been caused by an overreliance on portfolio insurance whose subsequent effects on the economy were quite fleeting. But the credit crisis of 2007 and 2008 was of a completely different order of magnitude. It exposed gaping holes in regulation, widespread lapses in judgment, and risk-management failures across huge swathes of finance. Its effects are of course still with us today in the form of unsustainable levels of government debt and (in the United States) stubbornly high unemployment. And much as we’d like to think that the crash to end all crashes has resulted in regulatory and systemic changes to ensure it will never repeat, the biggest change has been to investor risk appetites. The regulatory framework has tightened but not in ways that meaningfully address the causes. Big banks are still too big to fail, and so enjoy an implicit government guarantee. Capital standards are still too light on banks that trade for themselves and underwrite securities. The result is that the split of profits in banking between the providers of capital (investors) and labor (management and revenue producers) is too favorable to the latter. Requiring higher capital of the largest banks that do enjoy an implicit government guarantee would redress the imbalance. If bigger really is better in banking as some have argued, then bigger banks should be able to generate higher returns on capital and so cover the cost of maintaining even stronger balance sheets.

A number of fine books have been written on the credit crisis. Roger Lowenstein (The End of Wall Street), Michael Lewis (The Big Short), Andrew Ross Sorkin (Too Big to Fail), Gregory Zuckerman (The Greatest Trade Ever), and former Treasury Secretary Hank Paulson (On the Brink) cover the territory thoroughly and I won’t repeat here well-known episodes that have already been chronicled. John Paulson’s spectacular trade that profited from his early identification of the real estate bubble is accurately named in the title to Greg Zuckerman’s book, and surely every investment professional can only marvel at the insight and execution Paulson demonstrated at that time.

But as fantastic as Paulson’s, and a few others, results were, in general hedge fund returns in 2008 were of course breathtakingly poor. Losses were way beyond any reasonable expectations, as was in many cases the reaction of managers to the existential threats their businesses faced as a result. The hedge fund industry lost 19 to 23 percent for investors, depending on which return series you’re looking at and was truly awful by any measure. What made it even worse was that this result occurred after a period of unprecedented growth in the industry. Investors had been flocking to hedge funds as discussed in Chapter 1, and assets under management (AUM) had grown from $118 billion in 1997 to $2.1 trillion by the end of 2007, an 18-fold leap in only 10 years! A small percentage of the assets managed by the hedge fund industry had been around to enjoy the strong years of the late 1990s and 2003, and so 2008 was devastating to the aggregate results. In fact, in losing between $400 and $500 billion in 2008 the industry essentially wiped out all of the collective profits that investors had earned over the prior 10 years. Given how small the industry was before that, it’s probably safe to say that 2008 destroyed all the value that hedge funds had ever created. This does not mean of course that nobody had made any money in hedge funds, simply that the total of all the money made and lost by all the investors was, unfortunately, negative.

Whenever I interviewed hedge fund managers as part of our due diligence, I would routinely ask them how much we could expect to lose in a bad year. Risk is described in many ways. Back in the 1990s managers used to say they were striving for “equity-like returns with bond-like volatility” when equities were doing well. Others might describe their objectives as to outperform their peer group on a risk-adjusted basis, or even volunteer a specific return target range (say, 8 to 12 percent). None of these are necessarily bad answers, and asking open-ended questions can often elicit a greater understanding of the manager’s parameters. But ultimately risk is about how much you can lose, and the question was typically something like, “How much should I be prepared to lose on my investment before concluding that I should revisit my original decision to invest with you.” I haven’t asked this question since 2008 because I haven’t invested in a new hedge fund manager, and I imagine today’s answers might be different. However, a 10 percent loss was a remarkably common response to this question, with a 15 percent loss being the absolute worst case anyone should expect. That was then of course, and few of us thought equities could lose 37 percent in a single year either, which was the enormous mitigating factor for every investment manager in 2008. Nonetheless, hedge funds were long thought of as absolute return vehicles with results that are uncorrelated with traditional assets. The year when your equity investments are down 37 percent is precisely the year when you want your absolute return investments to look least like the rest of your portfolio, and hedge funds in general showed that in extreme times they have many of the same risks as traditional assets.

2008 also exposed some critical weaknesses in the way investors access hedge funds, normally through commingled vehicles, either limited partnership [LP] structures or offshore corporations in banking centers such as the Grand Cayman Islands. As discussed in Chapter 7, the LP structure provides significant business model benefits for the manager that are generally to the disadvantage of clients. By putting all the clients into one fund and then treating that fund as in effect one big client, the operational aspects of trading are greatly simplified. It also allows the manager to withhold detailed information about what positions he’s actually holding, making it harder for the investor to analyze results and determine whether they’re as good as they should be given the risks involved. Managers can use the LP structure to avoid negotiating concessions (on fees, for example) to investors by arguing that all the LPs in a given fund have to be treated equally. Nonetheless, sideletters are often used to define special rights an investor has that are not afforded to all the other investors, and so some investors then incorporate “most favored nation” clauses. This is a catch-all that basically says, “… if you give somebody else a better deal than mine you have to come back and give it to me too.” But at the end of the day investors are dealing with the manager bilaterally, and can rarely act in concert with one another.

The Hedge Fund as Hotel California

The ability of investors to withdraw their money from a hedge fund varies widely depending on the liquidity of the underlying strategy and the strength of demand a manager assesses amongst his clients. Really, redemptions should only be affected by liquidity, but stable capital makes for a stable business. Permanent capital, with no possibility of withdrawal, is every large manager’s ultimate goal. The security of knowing that investors cannot flee at the worst time, forcing the manager to possibly dump securities at fire sale prices, can provide access to highly illiquid but deeply underpriced investments and certainly has its place. However, capital generally likes to know it can be moved if needed, and the open-ended fund structure that is widely prevalent has met the needs of managers while being accepted by investors. 2008 threw up numerous examples of the impediments to liquidity that were not all the result of dysfunctional markets. Just as in the song by the Eagles, some investors found that they could check out but never leave.

Gate is a term applied to restrictions a manager can impose on investors trying to withdraw money. Generally speaking, a gate allows a manager to suspend redemptions if too many investors are trying to withdraw capital at the same time, which might require the manager to raise more cash than markets will easily allow. A fund might restrict more than, say, 10 percent of its capital from leaving at once, or may temporarily suspend redemptions during an unusual and temporary loss of market liquidity. Used properly, they’re a legitimate feature of the normal hedge fund structure. In fact, it’s hard to imagine a hedge fund operating without a gate unless it was in highly liquid instruments such as large-cap developed market equities or futures, for example. Many institutional investors even require such a feature before investing, so as to protect themselves against untimely withdrawals by too many other clients. Indeed, hedge fund investors care who the other clients are. Everybody wants long-term, stable money from people who will not panic during periods of turbulence. But the knowledge that a manager can restrict withdrawals can sometimes induce game theory type behavior from investors. Rather like a run on the bank, if you think others will ask for their cash and there’s only limited availability (i.e., the gate may be lowered), you’d better get your request in before others. Sometimes redemptions are met in sequential order, and sometimes all the requests in a given period (month or quarter) are treated equally. This is where you have to read the fine print. And sometimes an investor may put in a “contingent” redemption request, which basically means they may want to rescind it if, for instance, it turns out nobody else is redeeming and they fear not being able to return to what they think in the long run will be a good investment.

In many ways, investors are a large part of the problem. Managers often complain that investors don’t fully understand the strategy and so overreact at short-term volatility. Or that investors claim to be “long term” and not overly worried about month-to-month volatility when in fact they are anything but. Although there are plenty of exceptions, to a very large degree hedge funds have stuck to their strategies, followed their agreements, and done what they said. In many cases the disappointing results are as much the fault of investors as anything else. Poor analysis that fails to fully grasp the risks and intricacies of a strategy; momentum investing, chasing high performing managers without sufficient regard for whether the favorable environment for their strategy will persist or not; underestimating the negative impact of increasing AUM size (both for the industry as well as individual managers). These are all reasons why investors as a whole have not done as well as they should have. Hedge funds have responded to demand for a service and charged what the market will bear. But the best hedge fund managers are highly intelligent, and hedge fund managers overall are in my judgment smarter than their clients. Investors need to recognize their intellectual disadvantage and apply more skepticism to their often star-struck postures. As Warren Buffett famously said, if in a game of poker you don’t know who the patsy is, you’re the patsy!

So by the time 2008 rolled around hedge fund investors had more than $2 trillion invested across a wide range of strategies. This money was allocated in part based on past returns the industry had generated using far less capital, but at least for investors at that time this did not present a problem. Gates and other restrictions on investor withdrawals, concepts often clearly spelled out in documents but rarely dwelled on, all of a sudden became a very real concern. Whether investors needed money to meet other obligations (such as to fund prior commitments to private equity, or to meet their own withdrawals in the case of funds of hedge funds) or simply because they were nervous (and who wasn’t scared about the financial system itself at times in 2008?), gates and restrictions on redemptions became very real that year.

Part of the problem stemmed from the fact that managers often have substantial discretion in deciding that market conditions warrant such constraints being used. There’s no easy way to derive a legal definition of a dysfunctional market. It’s typically subject to the pornography test (“I know it when I see it,” as attributed to U.S. Supreme Court Justice Potter Stewart in Jacobellis v. Ohio, 1964). Given the weight of redemptions facing many managers during 2008, meeting them meant the possible failure of their businesses as remaining investors might flee on seeing a precipitous drop in AUM. While inconsistent with the spirit in which such restrictions are supposed to be imposed, at that time who could tell? The line between protecting investors and protecting a business became blurred in many cases, and investors relying on the open-ended fund structure to allow their exit found out the hard way that managers can maintain substantial control over their money.

AR magazine reported at the end of 2008 that requests to withdraw more than $100 billion were submitted in the course of that year, and that 10 to 15 percent of total industry assets were being sought (Williamson, 2008). Many large and well-known hedge funds saw fit to place restrictions on their clients’ ability to withdraw capital. A partial list (Brewster, 2008), with each fund’s AUM in parentheses where available, includes:

In fact, because some widely respected funds such as Tudor saw the need to suspend redemptions it greatly lessened the stigma associated with such a decision.

A quite staggering episode involved Randy Lerner, billionaire owner of the Cleveland Browns NFL franchise and Aston Villa (an English football club) in 2010. A dispute arose with a hedge fund he had seeded when he tried to withdraw his investment. The manager of the fund, Paige Capital, suspended redemptions because Mr. Lerner’s withdrawal represented more than 20 percent of the fund’s assets. Although this is not an uncommon mechanism to protect investors that don’t wish to redeem, in this case Mr. Lerner represented almost all the assets in the fund. It was in virtually all respects his fund. Nonetheless, the case wound up in court, and as (Vardi, “Billionaire Cleveland Browns Owner Claims Hedge Fund Is Hiding His Money,” 2010) memorably quoted from the court documents, “[W]e are fully prepared to litigate this matter to the bitter end because we will continue to manage your money, and collect management and incentive fees, until this matter is resolved many years hence,” Christopher Paige, Paige Capital’s general counsel, defiantly wrote in a March letter, court filings show. “You cannot win because you will spend more litigating than we’re fighting over … we decide the best way to protect the funds, and your opinion is irrelevant.” This was to say the least an unconventional reaction from a fiduciary.

In August 2011 a court ordered that Lerner’s money be returned. (Kaulessar, 2011).

One fund that surprised me personally was the London Diversified Fund. This was run by Rob Standing and Dave Gorton, and was spun out from JPMorgan London’s Rates business. I had known Rob for many years, since the merger between Manufacturers Hanover Trust and Chemical Bank in 1992. Rob managed Chemical London’s trading business in interest rate derivatives and continued in that role through subsequent mergers with Chase Manhattan and JPMorgan. As I came to know Rob, I developed enormous respect for his intellect and trading ability. He had an uncanny ability to immediately see through an issue and accurately assess how markets would react. He enjoyed enormous admiration amongst his traders in London and led them to consistently higher profits year after year. One of his senior traders, the quietly spoken and thoughtful Ashley Bacon, once said to me simply that, “Rob is always right.” Not in the way that Rob always believed he was right (though he was rarely burdened by self-doubt) but that Rob was simply right when it came to assessing how a market or derivatives relationship would react. That was pretty high praise, since I’d found Ashley was usually right too!

Dave Gorton was a highly successful proprietary trader who worked for Rob Standing. Dave was very talented, combining the detailed yield curve analysis that was the hallmark of the entire London trading room with sound judgment about the short-term trends that could provide good entry and exit points for his trades. He took very large positions, so large in fact that the bank had brought in outside capital for him to trade alongside its own. Dave was able to exceed Chase’s risk appetite, but his consistent profitability attracted traditional hedge fund investors. Essentially, the London Diversified Fund was born out of Rob Standing and Dave Gorton’s ability to generate growing trading profits that outgrew the availability of internal capital.

Although Rob had responsibility to oversee dozens of traders with substantial levels of risk and profit and loss (P&L), he maintained a seat on the trading desk and was most often to be found sitting there trading like everyone else, the ultimate player-coach. By then Rob’s trading positions were rarely the largest, but his results were consistently among the most stable in the trading room. Dave Gorton once memorably confessed to me that, “I just look at what positions Rob has on and then do 10 times the size.” In that one brief sentence he illustrated his enormous respect for Rob as well as his own almost limitless self confidence.

In 2002 Rob Standing, Dave Gorton, and a handful of others left JPMorgan and set up London Diversified Fund (LDF) as an independent hedge fund. It was a great deal for them financially, since they were able to retain the capital they were managing while at the bank. They continued their steady profitability over subsequent years.

But something went wrong for them during the credit crisis. I recall meeting with Rob in London in late 2006, when markets were strong and there was no apparent sign of looming financial disaster. Rob was very concerned; he felt markets were fragile, and that the regulatory authorities had a very tenuous understanding of the financial system’s vulnerability. I must confess the signs weren’t nearly as apparent to me, but I listened as Rob quickly articulated his case factually but with judgments blended in. And as is so often the case, he was right. Only this time, unusually and maybe uniquely, his risk positions and P&L didn’t reflect his insight. For 13 years prior to 2007 LDF had averaged 12 to 14 percent annual returns, with their worst losing period being −3.2 percent. In terms of return versus risk, this must have been one of the best track records around. Then in 2008 as the crisis took hold, they dropped 28 percent.

I wasn’t in contact with them during this time, but people I spoke to who were described how the traders under Dave’s direction had moved away from the generic interest rate derivatives and government debt trading that was for so long their bread and butter, and had begun taking positions in less liquid, more complex securities including mortgages. It was evidently a step too far away from their expertise and the resulting losses were many times greater than any of the investors might have reasonably expected. Of all the hedge funds in the world, I was probably more familiar with LDF’s trading style than any other through our shared background in the same trading division at Chemical Bank and Chase in the 1990s. Although I wasn’t a client of theirs, I would have felt safer investing with Rob than any other hedge fund manager in the world. Events and people can surprise you. Their business of course shrank, falling from more than $5 billion to less than $500 million. Rob and Dave carved up the capital so as to trade independently of one another, and the page was turned on that chapter.

Incidentally, their marketing guy Mark Corbett saved one of my clients a great deal of money through hubris. Mark was in the right place at the right time; when I first met him he was in an operational role supporting the trading business at Chase London. His was essentially a back office position, involved in the necessary details of accounting and trade settlement that take place in the background but far away from the thought process through which money was made. In time he took on a more public role representing LDF to outside investors, both before the fund was spun out of JPMorgan and afterward. In fact, he became a very able spokesman for the fund and was able to talk credibly with people about the positions they took and their risk controls, even though he’d never held a trading position himself. One investor once commented to me after seeing Mark give a presentation what a talented trader he was, and I wouldn’t be surprised if some people thought Mark really was the brains behind the operation.

Part of Mark’s role was to jealously protect Rob and Dave’s valuable time. Meeting with clients or prospects meant fewer hours spent analyzing the markets. Clients were not allowed to meet with both Rob and Dave together, and potential clients had to first go through a meeting with Mark to establish that a subsequent follow-up with Rob or Dave was going to be worthwhile. Masters of the Universe can manage their time in this way, and placing the client in the role of supplicant establishes very clearly who has the upper hand in the relationship. My client, the CIO of a large pension fund (we’ll call him George, not his real name) wanted to meet Rob and Dave because he was considering an investment. George wasn’t based in London but was going to be there on business and wanted to meet the principals. Mark wouldn’t allow this departure from his normal role as gatekeeper and screener, so politely refused. I even called Rob and explained George was a very knowledgeable investor who didn’t have time to meet their former operations guy first, and although Rob agreed, the next day Mark called me to reassert his control of the castle. He chided me for trying to run around him; there were to be no exceptions.

Fortunately, George had the good sense to know when his time wasn’t being respected, and as a result no meetings took place. We should have thanked Mark, he saved at least one investor some money.

Some hedge fund managers tried cutting fees in order to encourage investors to look beyond their immediate needs for cash. While few would describe hedge fund fees as low, if your interest is in retrieving your capital urgently for fear there will be less of it if you delay, reducing the normal 20 percent incentive fee to 15 percent (as Ramius Capital did) (Avery, 2008), which might improve later returns by perhaps 1 percent, scarcely seems as if it should alter the overall risk assessment. It was a nice gesture though. London-based Centaurus Capital offered (Mackintosh, “Record 40 billion is redeemed from poorly performing hedge funds,” 2008) to charge 1.5 and 15, a 25 percent cut, and allow investors up to 30 percent of their capital back if they would lock up the remainder for a further 12 months. Camulos Capital similarly offered to cut fees for investors who would agree to remain invested (Taub, 2008). In spite of these and other concessions borne of desperate times, the fee structure for hedge funds in general didn’t really change much.

In addition, large numbers of funds closed down following large losses, including Ospraie, Drake Capital, MKM Longboat (Mackintosh, “Hedge fund withdrawal expected by managers,” 2008), Peloton, and many others. JWM Partners, John Meriwether’s Phoenix-like return after he almost took down the financial system in 1998 with Long Term Capital Management, was down 26 percent (Rose-Smith, 2008) through October 2008. While in life people often deserve a second chance, you have to wonder at the judgment of the investors who went into JWM after Meriwether wiped out the first set of clients. What exactly is the analysis that concludes it’s an attractive opportunity, apart from a conviction that lightning doesn’t strike twice? Whatever John Meriwether’s investment skills, his marketing abilities are clearly stronger.

Timing and Tragedy

The collapse of Lehman Brothers in September 2008 triggered all kinds of unexpected consequences. Many hedge funds had obtained prime broker financing from Lehman’s London subsidiary which allowed them to circumvent Federal Reserve constraints on leverage (known as “Regulation T”). When Lehman filed for bankruptcy protection under Chapter 13 of the U.S. bankruptcy code, its London subsidiary fell under U.K. bankruptcy law, which, as everyone soon learned to their dismay, operates differently and with apparently less urgency than in the United States. Many otherwise-solvent hedge funds with collateral now locked in Lehman International faced very real difficulties in meeting client redemptions. To name just a couple, New York’s Bay Harbor Management had $190 million seized (Adamson, 2008) and Harbinger Capital Partners was looking for $250 million. MKM closed down their $1.5 billion multi-strategy fund because of poor performance but also because of their Lehman exposure. In an ironic twist, many hedge funds were forced to restrict client redemptions because they themselves had been restricted in accessing their capital from Lehman. While many of the events were almost impossible to anticipate and may well qualify as the proverbial thousand-year flood, the complexity of the hedge fund structure rendered many of these risks unknowable to investors. I attended meetings that year during which we quizzed managers on their prime broker relationships and Lehman was a concern for some time prior to their failure in September. But few could have been aware of the additional exposure created by a trans-Atlantic bankruptcy straddling two quite different sets of statutes and credit treatment.

One tragic story I followed concerned Marc Cohodes of Copper River. Marc’s fund was a short seller, one of only a handful of hedge funds that sought to make most if not all of their money by shorting stocks. Copper River was originally known as Rocker Partners after its founder David Rocker. David was based in New York while Marc was in California. Following David’s retirement the name changed to Copper River and Marc assumed full control.

Hedge fund managers that concentrate on running short portfolios are among the most thick-skinned people in the industry. Many hedge funds short stocks, and that in itself is a fraught activity. Significant forces are lined up against you—for a start, the target company’s management may vilify you and engage in all kinds of attempts to discredit you and cause the stock price to rise, costing you money. For a case study of how this can happen, go no further than David Einhorn’s absorbing story, “Fooling Some of the People All of the Time” in which he recounts his multi-year battle against Allied Capital’s fraudulent accounting. David was ultimately proved right, but retaining the conviction of his research required unimaginable fortitude in the face of government indifference and Wall Street opposition. Shorting stocks requires borrowing them for extended periods of time, which requires ensuring their long-term availability. And there’s always the possibility of a short squeeze, when speculators may buy the target company’s shares in the hope of forcing the short seller to cover his position, driving the price up even higher. The basic math is also adverse, in that an unprofitable position grows while an unprofitable one shrinks (quite the opposite of what happens if you’re long). This is because the market value of a position goes up when the stock price rises, and it falls when the stock falls. A basic measure of risk is to look at the size of the position. If a long position doubles in value, it’s typically thought of as more risky because a 10% move in the price now has twice the impact. This is just as true if it’s a short position—a doubling in price for a short position also doubles the risk. The problem for the short position is that losses can grow quite rapidly if the stock rallies, and at least theoretically there is no limit on how much you can lose. Meanwhile your maximum profit is limited to the price you sold the stock at—it can’t go below zero. So shorts assume more risk as they rise in price, meaning that a losing position becomes a bigger one. This is quite the opposite of what happens with a long position, since it becomes bigger only by being profitable. As a result of all this, the research that’s required to justify a short position has to be exhaustive. It’s a hard way to make money.

But while many hedge funds short stocks, very few limit themselves to only shorting stocks. They are a breed apart. Typically they combine the requisite deep research on individual companies with a broader conviction that the entire financial system is at risk, and very dark times lie ahead. Many long/short hedge funds maintain a net long exposure to the market because they believe over time the market rises. They incorporate the higher long-term returns they expect from stocks into their risk profile. Meanwhile, short selling funds have the opposite worldview. They see a great deal wrong with the world, and anticipate financial destruction, depression, mass unemployment, and all manner of terrible outcomes for the global economy and society as a whole.

On top of this, they often believe that the companies they short are riddled with criminal behavior and will ultimately go bankrupt. They expect management to one day be led out of their offices handcuffed and in full view of the TV cameras (the so-called “perp walk”) as the ultimate vindication of their detailed research. Most investors will recognize that even the greatest companies can have an overpriced stock, and be willing to separate a well-run business from a poor investment. Short sellers believe the annihilation of their shorted stock is inevitable. The only fair price is $0.

In early 2008 I was at a conference where Marc Cohodes spoke about his investments. His outlook was negative; already cracks were appearing in the mortgage market, and the consequences of America’s profligate behavior were about to become devastatingly clear. Marc’s entertaining speech then continued to identify specific companies who were vulnerable. He held up a newspaper ad for Jos. A. Bank, the men’s clothing retailer. “Buy one suit, get two free” he shouted. “How is this possible?” Marc went on to pick apart the company’s business model, noting that they possessed no sought-after patented technology and operated in a fairly mundane, competitive marketplace. How could they possibly survive, undercutting the competition by so much? Ultimately their cashflow would falter and the whole deck of cards would come tumbling down. Jos. A. Bank surely had to be engaged in some very questionable accounting practices, and like any dodgy scheme its collapse was only a matter of time. Marc was shorting their stock.

2008 should have been a spectacular vindication of Marc Cohodes. The unthinkable, which Marc had been thinking for a long time, very nearly came to pass as the entire financial system teetered on the verge of collapse that September. Every asset was down, except for riskless government bonds. Seemingly, a short position in just about any security would have generated a handsome profit. Marc had been anticipating this for a very long time. Lehman’s bankruptcy should have been his crowning glory, and in a year when hedge funds were losing hundreds of billions of dollars for their clients, Copper River should have been the champion, the winner when most were losers, the fund that showed who really deserved the word “hedge” in their description. But things did not turn out that way.

Copper River had put on short positions using Lehman as a counterparty. When Lehman failed on September 15, Copper River wound up like so many other hedge funds, with collateral tied up and at least temporarily inaccessible. On top of that, Lehman then closed out the short positions they had put on to hedge their trades with Copper River, driving up the prices of the stocks Marc was short. Then on September 19, the Securities and Exchange Commission (SEC) issued unprecedented restrictions on short sales of a number of companies including banks, which caught the market off guard and caused a sharp rally in the prices of many financial stocks. Copper River reported to investors that over two weeks they had lost 55 percent of their clients’ capital (Boyd, 2008). Within months the business was closed down in the face of heavy redemptions. Almost everybody had a bad year in 2008, but one can scarcely imagine the abject frustration Marc felt as he contemplated the gulf between his views and the financial results he had to show for it. Few people deserve sympathy for that year, but Marc may be among the small minority that merits consideration.

Almost every day I walk past the local Jos. A. Banks store. They’re still offering incredible deals on men’s suits, and their stock made a new all time high in 2011. I don’t know how they do it, but it seems they still do. The story of Marc Cohodes is as close to a tragedy as you’ll find in the hedge fund industry.

In 2008, Down Was a Long Way

Observers worried quite naturally about the very survival of the hedge fund industry. Daniel Celeghin, a director with Casey, Quirk & Associates, commented “The key question right now is: Does the hedge fund industry survive in its current form?” He went on to add, “If it does not survive, it will be because financing has changed drastically.” (Rose-Smith, “Goodbye, easy money,” 2008) Meaning that both the terms under which hedge funds borrowed but also the terms investors faced as clients were destined to change to reflect the new reality. Marc Freed of Lyster Watson (a hedge fund investor) noted that as much as $400 billion was locked up and added “There are more assets frozen in suspended hedge funds than the $325 billion distributed to date under the Tarp (Sender, 2008).” Subsequent data from BarclayHedge suggests that about $180 billion was withdrawn in 2008 as the industry shrank from $2.1 trillion in AUM to $1.5 trillion (negative performance accounted for the balance of the shrinkage in AUM), and a further $100 billion was withdrawn in 2009.

As the year wore on, observers increasingly feared for the survival of hedge funds in anything like their current form. For example, in October 1988 Mick Gilligan (Johnson, 2008), collectives analyst at Killik & Co, a London-based broker, said: “Whenever we speak to people at hedge fund groups they say they have had large requests and they expect to have large requests to the year end. There is a huge deleveraging process going on. A lot of money went into hedge funds in recent years and a lot of that was safe haven money, and that will be coming out.”

As the industry speculated about which funds might be forced to liquidate positions to meet redemptions, attention focused on positions believed to be widely held. Goldman Sachs (and no doubt others) maintained a list of 50 “very important” hedge fund positions and in one research note said that “forced selling to cover redemptions and deleveraging by hedge funds has put downward pressure on selected stocks.” (Sender, “Hedge funds exploiting rivals’ woes,” 2008) Like a group of drowning men struggling to survive, traders were pushing each other underwater in their efforts to stay afloat.

Summary

2008 was a year that redefined for investors how bad things could really be. Hedge funds were certainly not alone in losing far more for their clients than anybody previously thought possible. Stocks, bonds (other than government bonds), emerging markets, private equity, and of course real estate all delivered thumping losses as the financial system very nearly collapsed.

As the Wall Street Journal noted in its review of 2008, some notable hedge funds were forced to close, including Peloton (a London-based fund invested in mortgages) and Ospraie’s biggest commodity fund run by Dwight Anderson, while many high profile funds including Citadel and Highbridge Capital Management suffered deep losses. Citigroup had bought fund of hedge funds Old Lane Partners in 2007 with the idea of jumpstarting its hedge fund activities for clients. Co-founder Vikram Pandit negotiated the $800 million sale and joined Citi as a senior executive, ultimately taking over as CEO later that year.

Having generated a no doubt substantial part of his personal net worth through that well-timed sale to Citigroup, Pandit as CEO then oversaw the complete write down of the investment as Old Lane added to the financial giant’s losses in 2008. As they say, you just can’t make this stuff up.

The hedge fund industry additionally had to deal with the massive fraud of Bernie Madoff, which provided nervous hedge fund investors further reason to worry not just how much money they had left but whether it was really there at all.

However, amidst all the financial destruction were the seeds for recovery, and phoenix-like markets and hedge funds rebounded the following year. For the survivors of 2008, those who had managed to preserve enough capital to be buyers, almost every market offered opportunities rarely seen before. The rebound had begun.