Why Down 1.5% Matters

Overall, convertible-bond hedge funds lost 1.5% in May and are down 6.8% since the start of the year, according to data from Hedge Fund Research Inc.

Losses were particularly steep at GLG Partners, London, one of the world’s biggest managers of hedge funds, with more than $10 billion in assets. The firm’s Market Neutral fund, one of the world’s biggest convertible-bond hedge funds, with about $3.5 billion in assets, returned a negative 7% last month, according to people familiar with the matter. The fund is down about 15% for the first five months of the year, these people said. The firm declined to comment. –Wall Street Journal

Some people reading that might wonder—what’s so horrible about down 1.5% in a month, or even 6.8% year-to-date?

After all, we’re talking about hedge funds. And in the world of hedge funds, being down 6.8% can happen—depending on the hedge fund’s investment style—before lunch.

Many of the best funds I’ve known have suffered that kind of volatility while accumulating terrific returns over the long haul. Read Jim Cramer’s excellent “Confessions of a Street Addict” to get an idea of what it’s like to be down ten, then twenty, then thirty per-cent, with redemption notices coming in over the fax machine, unable to sleep, eat, think clearly.

Cramer—with the help of his wife, “The Trading Goddess,” and Alan Greenspan’s interest rate cuts—turned his hedge fund around and exited the business on a high.

But innumerable—and I mean that literally—hedge funds have come and gone over the last thirty years, done in by a down 30% year with no hope of climbing back out of the hole. The Granddaddy of them all, Long Term Capital Management, lost 100% of its money and almost took down the entire world financial structure.

So when you see a class of hedge funds down 1.5% in May and down 6.8% year-to-date, you might wonder, “What’s the big megillah here?”

The big megillah is that the convertible-bond hedge funds of which the Wall Street Journal writes are no ordinary hedge funds comprised of “qualified” investors—meaning “rich enough to lose it all”—who accept short term volatility for outsized long term gains.

Rather, these are funds designed to appeal to institutional investors, particularly life insurance companies, seeking consistent, higher-than-the-alternative returns with no capital risk, whether the equity markets are up, down or sideways.

These are funds that aim to provide 1% a month, no strings attached.

I’m not making this up: 1% a month is the implicit promise for many of these “market-neutral” black box Masters of the Universe convertible arbitrage funds. The life insurance companies love them because 1% a month compounds to something nicely above the 4% long bond yield, and since they’re not trading currencies or betting on biotech discoveries, the convertible funds fit the risk profile of a safe, conservative bond portfolio.

But if that 1% a month turns negative, even for half a year…it screws up the entire picture. Suddenly, the capital account is negative, the return calculation goes out the window, and a loss which for many hedge funds—especially the old-fashioned long/short equity funds—might seem like a day at the beach, becomes a crisis.

The life insurance company is going to say “no mas” and yank the capital—especially now that short rates have tripled in the last year, and the risk-free alternative looks a lot better better than a year or two ago.

Which is why down 1.5% in a month and 6.8% for half a year is, as they say, unacceptable.

The markets began freaking out about the convertible arbitrage business two months ago, helping create a short-term bottom in the equity market and a sigh of relief in the Wall Street Journal.

But with end of the quarter approaching, expect the headlines to reappear and some strange action in the markets: there will be more than a few life insurance companies, and other institutional investors, looking to get their money back.

Or what’s left of it.

Jeff Matthews I Am Not Making This Up NB: The plug for Cramer’s book is no mere logrolling given my past association with TheStreet.com: I think there is no better description of what it is like to be inside the hedge fund vortex during a time a financial crisis than that in “Confessions.” I rank that book right up there with “Reminiscences of a Stock Operator” and the “Money Masters” series by John Train.

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations.