11 August 2007

Big liquidation triggers hedge-fund turmoil

Some compare upheaval to LTCM collapse; market-neutral funds are hit hard
By Alistair Barr, MarketWatch

SAN FRANCISCO (MarketWatch) -- The liquidation of a big hedge fund or investment-bank trading portfolio is wreaking havoc in some parts of the hedge-fund business, managers and investors said Thursday.
Black Mesa Capital, a hedge-fund firm that uses computer models to track down investment ideas, said that at least one large hedge fund or investment bank is liquidating "massive" trading portfolios, according to a letter the Santa Fe, N.M.-based firm sent to investors Wednesday.
'Clearly, something is amiss in the markets that few in our strategy, if anyone, have experienced before.'

— Letter to Black Mesa investors
The warning is causing disruptions and triggering big losses among other so-called market-neutral hedge funds, Black Mesa said in its letter, a copy of which was obtained Thursday by MarketWatch.
"Clearly, something is amiss in the markets that few in our strategy, if anyone, have experienced before," Black Mesa's managers, Dave DeMers and Jonathan Spring, wrote. DeMers declined to comment Thursday.
The firm's hedge fund, which has about $1.9 billion in long positions and $1.9 billion in short positions, was down roughly 7.5% this month through Aug. 7. Those losses could grow to as much as 10% for August so far, Black Mesa noted.
A $700 million hedge fund run by Goldman Sachs (GSGoldman Sachs Group, Inc

GS ) , the North American Equity Opportunities fund, has sold some of its positions recently after losses, a person familiar with the matter said on Thursday. Goldman's biggest hedge fund, the Global Alpha fund, has suffered losses and may also be selling positions, but the person stressed that this fund is not shutting down.
'Quant' quake
The Global Alpha fund, which manages $9 billion, is a so-called quantitative fund, using computer models to locate investment opportunities.
Such "quant" funds are popular among hedge-fund investors. Many use a market-neutral strategy, which aims to balance long positions with short trades, or bets against securities. Others are so-called statistical arbitrage funds, which analyze the historical relationships between related securities and trade when those relationships get out of whack.
Many players in this part of the hedge-fund business have similar positions and use lots of leverage, or borrowed money, to increase their bets. However, that magnifies even small losses. Some of these hedge funds also have relatively permissive redemption periods, allowing investors to take their money out every month, with 30 days' notice or less.
So if losses trigger investor redemptions, these funds may have to sell lots of their positions. That, in turn, puts more pressure on the historical relationship between related securities, handing more losses to other hedge funds in the space.
If such positions are sold by lots of managers at the same time, the most leveraged funds get hit the hardest, possibly forcing big liquidations of portfolios, which triggers a chain reaction.
Two hedge-fund investors who didn't want to be identified said the current turmoil is reminiscent of the 1998 collapse of Long-Term Capital Management.
That giant hedge fund had some arbitrage positions based on the historical relationship between related securities. It made bets on the relationship between the prices of government securities from around the world. When Russia defaulted and devalued its currency, the ruble, there was a flight to quality that caused the prices of U.S. Treasury securities to spike.
LTCM collapsed amid rapid market dislocation and had to be bailed out by several of the world's largest investment banks as part of a plan organized by the Federal Reserve.
On Wednesday, Black Mesa told investors that other market-neutral hedge funds had suffered losses of between 5% and 15% so far in August.
The Highbridge Statistical Market Neutral Fund, a $1.8 billion hedge fund run by the J.P Morgan Chase (JPMjp morgan chase & co com

JPM ) unit Highbridge Capital, fell more than 5% this month through Aug. 8, according to the bank's Web site. The fund uses computer models to pick undervalued and overvalued securities and maintains roughly equal positions on both sides to iron out the effect of broad market fluctuations.
Hedge fund investors also highlighted other firms that use quantitative and market neutral strategies, but it's not clear whether these firms have suffered losses.
Barclays Global Investors, the money management arm of U.K. bank Barclays PLC (UK:BARC: news, chart, profile) , is one of the world's largest quantitative fund managers. The firm also runs market-neutral hedge funds.
It's not clear whether Barclays funds have suffered any losses recently. Spokesman Lance Berg declined to discuss performance or the strategy of the firm's hedge funds.
"At this time we are maintaining risk levels and feel that our portfolios are positioned appropriately," Berg said.
AQR Capital, Algert Coldiron Investors and Tykhe Capital were among other hedge fund firms mentioned by investors. Representatives at those firms didn't return calls seeking comment on Thursday.
The Wall Street Journal reported that Tykhe, run by former D.E. Shaw managers, has suffered losses of about 20% in August, and is moving quickly to trim its investment positions.
Similar to Amaranth
Black Mesa said it started reducing its leverage and selling positions to raise cash on Monday. As of Aug. 8, the firm said it had between 50% and 100% of its portfolio in cash and had brought leverage down to 0.5 to 0 times its assets, according to the letter.
The market disruptions began on July 25, when Black Mesa spotted signs of a major liquidation by another market participant. That continued through the week, handing the firm its biggest losing day ever, when it was down 3% on July 27.
The firm analyzed what caused its losses over that weekend and concluded that the behavior of the markets were similar to mid-September 2006, when giant hedge fund firm Amaranth Advisors liquidated its market-neutral equity portfolio to meet margin calls triggered by energy trading losses, Black Mesa explained.
'Me-too' liquidations
As August began the selling continued, the firm said in its letter.
"Either the original liquidators had just paused, and/or others had begun to liquidate their market-neutral books on Wednesday, August 1," DeMers and Spring wrote. "By Friday, August 3, there seemed to be no abatement in the liquidations and over the weekend, we confirmed with other market-neutral managers that they were suffering similar losses."
Black Mesa then began to wonder whether others in the market-neutral space, having learned of these liquidations and having lost money themselves, could start cutting leverage in their own portfolios too.
"There was (and is) the possibility that, as great as liquidations had been so far, that it was just the beginning of a spiral of me-too liquidations," DeMers and Spring wrote.
The two managers said they didn't know now long such dislocations could last, noting that it could be two days, two weeks, two months or even two quarters.
Black Mesa said there are now "enormous profit opportunities" but the firm said it remains on the sidelines until signs of liquidations in the market dissipate.
Alistair Barr is a reporter for MarketWatch in San Francisco.

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