London - Nervous hedge funds managers are stress testing
their portfolios and searching for ways of protecting themselves against their
worst nightmare - a potential breakup of the eurozone.
With talks on restructuring Greece’s debt mountain still
deadlocked, and the exit of one or more countries from the euro seen as a small
but definite possibility, funds are modelling scenarios ranging from a 50%
slump in European stocks or a 45% fall in the oil price to a 30% rise in gold.
Managers are also trying to dig out old computer programs
they once used to model the behaviour of currencies such as the drachma or the
deutschmark as they prepare for an event for which - even after the 2008
collapse of Lehman Brothers - they effectively have no precedent.
Many, having already trimmed risk, are piling into credit
default swaps or deeply out-of-the-money options, hoping they pick a
counterparty that can withstand the shock of a break-up.
“You can’t conceive what this event will be like, but it
doesn’t absolve you of looking at it,” said the chief risk officer at one hedge
fund firm who asked not to be named.
“People are asking the questions, 'do I have the historical
records on how things worked when there was a deutschmark?’ and 'did I throw
away those computer programs (modelling the deutschmark)?'.”
Funds are also trying to figure out how they might be
affected if different asset classes that normally have a low correlation start
to fall sharply at the same time.
“Anyone who’s a chief risk officer is running these
scenarios - say if the euro falls 15%, stocks fall 25%, if the possibility of default
increases, what if recovery rates fall, which prime brokers, administrators
get hit?” said Mark Wightman, head of strategy for Asia-Pacific at specialist
technology group SunGard.
“The scenarios are getting quite complicated and people are
starting looking at correlations between things to understand the likely
impact.”
Protection
While hedge funds, which can put on short positions, have
more tools at their disposal than long-only funds to cope with market falls,
their performance has been patchy.
Last year they lost just over 5% on average, according to
Hedge Fund Research, while the S&P 500 delivered a total return of 2.1%
That was their second calendar year of losses in just four years after heavy
losses during the credit crisis in 2008.
Many hedge funds have already cut exposure to assets seen as
directly in the firing line such as the euro or European stocks, insiders say,
but are finding their options limited.
“We’re all still trying to run our businesses right now. I’d
like to say I’ll put everything in US dollars, but you can’t,” the hedge fund
chief risk officer said.
“Part of it is contingency planning - what you need to get
out of first - and part is proactive - 'I don’t need so much emphasis in a
certain area right now’, such as European stocks or the euro,” he said.
“Certainly we are taking smaller positions in some of these
markets.”
Some funds also rejigged their equity short positions after
major differences between stronger, core economies such as Germany and weaker
peripheral economies became more apparent, said one investor who spoke on
condition of anonymity.
For instance, a manager who owned shares in a German bank
while shorting a Greek bank has switched to hedging the German bank with a
short position on another German bank, after the Greek bank’s shares “started
to take on a life of their own” as a result of the country’s debt crisis, the
investor said.
However, with uncertainty over which currencies would exist
after a breakup and how they would behave, funds are still unsure how far
their hedges would protect them.
“A hedge fund may have a hedging programme that is very
highly attuned to dealing with its positions. But the day after something
happens there’s no programme to deal with this and their hedge may be
denominated in a new currency,” the risk officer said.
Avoiding contagion
Part of the dilemma is a mistrust of value at risk (VaR), a
standard measure used by banks to show estimated potential loss, expressed with
a certain percentage level of confidence.
“A traditional measure of risk like VaR has nothing to say
on this,” said Lance Smith, CEO at US-based Imagine Software, which has been
working with hedge funds to assess the impact of a eurozone breakup on their
portfolios.
“A euro breakup could be a 7 standard deviation event. A
6.5 standard deviation event occurs once every 34 million years, while a 50%
fall in the Eurostoxx would be a 21 standard deviation event. This just
highlights the flaws in a standard statistical approach.”
Credit default swaps (CDS), which are meant to pay out in
the event of default, currency options or deeply out-of-the-money options, are
among the favoured hedges, industry executives say, which has driven up option
prices.
However, even here there is a concern over whether the
counterparty can pay up.
“You watch the counterpart if (it’s) OTC (over-the-counter)
to avoid contagion,” said Sungard’s Wightman. “Thus you do your euro trades
with say Japanese, US, Asian or Australian institutions.”
Meanwhile, one hedge fund manager has structured a trade to buy
German bunds while offsetting this with credit default swaps, one fund
selector told Reuters.
“His base case is that if someone comes out of the euro, the
German bund will be the place to be.”