Tag: spring2009

Hedge funds have long been considered among the most lucrative investment vehicles, employing a variety of often high-risk, high-return strategies for wealthy investors. But the news these days from hedge funds—estimated to represent nearly $2 trillion in assets—is no longer rosy, with funds down more than 17 percent in 2008 alone. The secretive world of hedge funds is facing unprecedented challenges as the global financial market turmoil continues and the industry rapidly heads toward its biggest losses in history.

In the face of such staggering losses, funds are liquidating in record numbers, with 693 funds going bust in the first nine months of 2008, or nearly 7 percent of the entire industry. And the worst may be yet to come, with one prominent hedge fund executive telling a conference recently that about 30 percent of hedge funds may fold completely as a result of the current crisis.

As the perceived risk of failure rises, investors tend to rapidly increase redemption requests to exit from funds. Standing in their way can be all sorts of redemption restrictions that can result in heavy penalties. In October 2008, about 18 percent of the hedge fund industry assets were subject to withdrawal restrictions, according to Singapore-based consulting firm GFIA Pate. And anecdotal evidence suggests that withdrawal restrictions are quickly gaining ground as funds attempt to curtail capital drain.

Although certain restrictions on the ability of investors to redeem their capital from hedge funds—such as lockups and notice periods—are well defined, the ability of managers to suspend withdrawals is often vague in partnership agreements. In some cases individual fund managers retain varying degrees of discretion when it comes to redemptions. “For instance, they may have the authority to process only a portion of a redemption request, known as a gate, retaining the balance of the investor’s capital, and some even have the right to suspend redemptions altogether,” says Nicolas Bollen, E. Bronson Ingram Associate Professor in Finance at the Owen School.

Bollen notes that it typically has been unclear exactly what withdrawal restrictions can mean in terms of cost to investors. Developing a research model that treats the ability of an investor to withdraw capital as a “real option,” Bollen—along with Andrew Ang, Professor of Finance at Columbia Business School—pinpointed the cost of liquidity restrictions by analyzing financial data for more than 8,500 live and defunct funds from the Center for International Securities and Derivatives Markets.

Bollen’s analysis discovered that withdrawal restrictions come with a hefty price tag for fund investors. According to the new study, implied costs to a hedge fund investor from such redemption restrictions can range from 5 to 15 percent at the time of the original investment, with exact amounts highly dependent on fund-specific attributes such as age, expected return and the loss generated by liquidation of fund assets.

“Given that most hedge funds require significant investment levels to begin with, the resulting costs of liquidity restrictions—whether existing or newly imposed—can potentially be staggering for investors,” Bollen states.

For example, an investor who deposits $1 million in hedge funds—a relatively modest allocation for such financial products—is essentially paying an upfront fee of as much as $150,000 if his or her ability to exit is eliminated through future suspension of redemptions.

Funds whose managers have greater discretion when it comes to withdrawal restrictions should be of the greatest concern to investors, believes Bollen. “These types of discretionary restrictions on withdrawals have the potential to impose much higher costs on investors than standard restrictions such as lockups and notice periods,” he says.

Given his findings, Bollen suggests that hedge fund investors carefully scrutinize redemption rules—and fund manager discretion—before investing. “We are now seeing that, in a serious downturn, investors can face heavy penalties and even be prevented from retrieving their capital should they seek to liquidate their investments, and the implied cost of these restrictions can significantly reduce the return that should be expected from funds,” he says.

As the world financial panic set in motion by the subprime mortgage crisis reached full steam in late September, Bob Whaley’s phone began ringing. Interest in what financial writers call the “Fear Index” was spiking as stock prices plummeted and major Wall Street firms collapsed, and much of it was directed his way. The Fear Index, which is more properly known as the Chicago Board Options Exchange Market Volatility Index (VIX) and which has offered a real-time gauge of market jitters since 1993, was, after all, Whaley’s brainchild.

Whaley, Valere Blair Potter Professor of Management and an expert in derivative securities, did some interviews, but became increasingly annoyed by the articles and commentaries he saw. One after the other contained assertions he saw as “utter nonsense”—that the VIX was a self-fulfilling prophecy, that it was at unprecedentedly high levels, that it was a contrarian indicator.

“People were saying all sorts of unsupportable things,” he says, “so I decided to write a short piece that puts everything in proper perspective and corrects misconceptions people have because they haven’t dug deeply enough.”

For most people, the VIX, like the wider world of derivatives it reflects, skulks in a back alley of the financial world until there is a crisis, when it is hauled in for questioning that amounts to hysterical accusation rather than rational information gathering. What’s more, the recent fates of even the biggest, most savvy firms make clear there was more than enough ignorance—coupled with greed—to go around. If ever a subject called for light rather than heat, it is this one.

“It is not new,” Whaley says of the index. “It is not at unprecedented levels. And it does not cause volatility.”

It is, he contends, simply “a measure of expected stock market risk” set by the actions of investors as they work to protect their assets. More fully, the VIX is a weighted blend of prices for options on the Standard & Poor’s 500 Index (prior to Sept. 22, 2003, it was the S&P 100). Those options are in essence insurance policies protecting investors against broad-based market swings. The premiums they are willing to pay indicate their level of apprehension—hence the term “Fear Index”—about the market volatility they anticipate in the short term.

Whaley is amused by claims that the VIX is a contrarian indicator.

“One commentator said in September that since the VIX was above 35 it was time to buy stocks,” he says. “The only time a contrarian indicator makes sense is after the fact. While 35 might have been high relative to its recent history, it increased steadily to a level of over 80 in the days afterward. If you’d taken his advice, you’d have lost your shirt. The stock market fell by nearly 30 percent.”

He is similarly dismissive of its power as a self-fulfilling prophecy that adds to market anxiety.

“This type of thinking is exactly backward. The degree of market anxiety is reflected in investor demand for portfolio insurance, which sets the level of the VIX. Saying that the market is better off without the VIX is akin to an ostrich hiding its head in the sand.”

As for historic highs, the VIX is in one sense nowhere near them—projected backward, it reached its peak during the October 1987 market crash, spiking to levels well above 150. Since September 2008—the month that marked the beginning of the stock market’s deep dive—the VIX has not exceeded 90. On the other hand, its recent sustained level of more than 35 marked only the fourth time the index had spent more than 20 days in that range.

“So, yes,” says Whaley, “we are experiencing abnormal behavior, but, no, it’s not unprecedented. We just tend to forget.”

This article is an abridged version of the one that appeared in the Winter 2009 edition of OwenIntelligence. To read it in its entirety, click here.

Imagine that you’re an NBA star instead of a stellar MBA. In fact you’re more than a star; you’re one of the top players. Then you make a dramatic career move, accepting a lucrative offer to be a head coach in the league.

Suddenly your job is to lead and motivate others who excel in the very skills you had mastered earlier. Your job no longer involves shooting, passing, rebounding, dribbling and playing defense. Instead you’re responsible for putting the right talent on the floor in the right situations. You have to manage a lineup of inflated egos while keeping everyone focused on working together. You have to map out winning strategies for every game and then communicate them effectively so your players can execute them. You’re also the most public face of the organization, with corresponding responsibilities in handling the media. Few of the skills that took you so far as a player will serve you in this new role. Now you feel all alone.

Michael Burcham, Professor for the Practice of Management, uses the NBA analogy to explain the thinking behind a new program at Owen, Thinking like a CEO, that he helps lead. Like star players turned coaches, CEOs—especially those who are newly promoted into the position or who have grown an entrepreneurial venture into a more substantive, structured enterprise—often struggle in their new roles and make common mistakes that, to outside observers, seem to violate common sense.

The course is the creation of three Vanderbilt professors: Burcham, David Furse, Adjunct Professor of Management, and Kimberly Pace, Clinical Assistant Professor of Management. They recognized a market need for CEO preparation based not on research but on their extensive, hands-on involvement in the world of corporate executives.

Burcham has started and led three health care companies. (He carefully balanced the operation of one, in New Jersey, with his teaching duties at Vanderbilt.) Furse was an entrepreneurial CEO with two decades of experience before joining the ranks of academia. Pace, who directed marketing and communications for two international firms, continues to coach and advise CEOs on managing their “personal brands.” All three professors consult regularly with C-level corporate executives.

Even experienced executives make monumental errors. But basic mistakes, the professors observe, are especially common among CEOs who came into their position through growing a small startup company or through excelling in one area of an established organization. “Some chief executives, for example, came up through a particular area of a company, such as marketing, and have a less-than-thorough understanding of the rest of the organization,” says Furse. “So they may starve the parts of the organization they don’t understand.” Others, who were stars in sales or operations or finance, struggle to learn that “they don’t get to be the star player anymore.” The job, rather, is about empowering everyone else in the company.

“Some CEOs are phenomenal at strategy but not execution,” Pace notes. “Some are good at execution but not strategy. If you’re an elite organization, you have to be great at both. You need the whole package.”

Younger entrepreneurs, in particular, says Furse, set a trap for themselves by trying to be everywhere. Once the organization grows, these startup executives fall prey to their own success. “You can’t directly manage the whole company anymore. You have to develop people and build a management team. A lot of the work we do is helping CEOs develop their senior management teams. No CEO can do it all.”

Burcham recalls one successful technology entrepreneur who was still trying to run his 500-person company the way he did “when it was just him and 15 software programmers.” It didn’t work.

“Few schools teach people to be a CEO,” Burcham observes. “People are promoted into the role. They get there through different skills, and these aren’t necessarily the same skills they will need as a CEO. If you bring a VP’s skills to the position of CEO, you’ll probably make a lot of the same classic mistakes that other CEOs have made.”

This article is an abridged version of the one that appeared in the Spring 2009 edition of OwenIntelligence. To read it in its entirety, click here.