Tuesday, February 13, 2007

The Great Unwind is coming, warn Dresdner pair

It’s the sort of analysis that, as an investment banking analyst focusing on the investment banking sector, might seriously damage your career prospects.

No matter! Stefan-Michael Staimann and Susanne Knips at Dresdner Kleinwort have published a detailed tome on the importance of hedge funds to the investment banking industry. Their conclusion? Head for the hills, because “The Great Unwind” is coming — and it’s going to hurt.

Here’s the thesis:

  • Transaction costs run to 4 per cent of the $1,300bn of hedge fund assets under management. Manager salaries and performance fees take another 4-5 per cent, meaning hedge funds need to generate average annual returns of close to 20 per cent to keep everyone (including their investors) happy. Yet the strategies employed to produce these returns are not necessarily sustainable.
  • A clear majority of hedge funds can be thought of as leveraged sellers of deep-out-of-the-money put options. They employ long-short strategies - removing market risk with what are essentially spread or arbitrage bets with a relatively low return. To boost returns they employ extensive leverage. These spread positions do produce what look like low-risk returns most of the time — but, once in a blue moon, what are effectively options written by the hedge funds will get called. Think LTCM.
  • While hedge fund strategies across the industry may look diversified, there is actually a high degree of correlation, since many funds are effectively running leveraged bets on stable or tightening risk premia. Any widening of risk premia will force large-scale liquidations of positions, with margin calls by the banks and redemptions by investors reinforcing the process.
Staimann and Knips declare: “We believe that the great unwind is inevitable, but impossible to time. It looks like the process of building up leveraged spread bets has already run quite far. Risk premia in many markets are very low, making it increasingly difficult to find spread bets for new money. Market volatility has been driven to record lows (remember: selling a put is like shorting volatility). The process may not have much more room to run and may start to be more sensitive to factors that could threaten its delicate balance (such as a deterioration of corporate credit risk).”

“The virtuous cycle on the slow way up (the supply and demand from building spread bets
leads to tightening spreads, which in turn raises confidence to build new positions) turns
into a vicious cycle on the fast way down.”

So how vicious is this great unwind going to be? Well, the Dresdner pair estimate that investment banks sucked roughly $40-50bn in revenue out of hedge funds last year, mainly through sales/trading and services other than prime brokerage. That is about 15-20% of all industry revenues in investment banking.

P.S. If you do get hold of a copy of the Dresdner report, do have a look at Appendix 2, titled “Are hedge funds banks. It compares Citadel with Deutsche’s investment banking division and, in a word, answers “yes” — and then goes on to compare Citadel with LTCM.

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