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Why the Swiss Franc Has Clobbered Hedge Funds

01/22/2015

The following blog was originally posted on Yahoo Finance.

This week’s news has revealed more hedge funds shutting down due to losses caused by the recent spike in the Swiss currency. Most prominently, COMAC, a London-based global macro shop run by well-regarded trader Colm O’Shea, is returning more than $1 billion in investors’ capital. The Reuters report on the shut-down quotes a COMAC letter to investors: “The [Swiss National Bank] decision to abandon the currency floor led to the most significant loss of Colm’s career and will have a substantial negative impact on the macro fund and firm.”

O’Shea is not alone. Everest Capital, a Florida-based emerging markets fund run by a portfolio manager with more than 20 years of successfully navigating volatile markets, is shuttering one of its main funds due to CHF-related losses. Another fund from the BlueCrest complex is also boarding its doors. I doubt any of us would be surprised to see more soldiers fall.

What in the world is going on here? For starters, unless you have a direct access to the structure of these funds’ portfolios, you don’t know exactly what drove these losses (or even how exactly big the losses were). The directional story is pretty easy to surmise. These funds were short the CHF, so its sharp, immediate spike after the Swiss National Bank lifted its cap triggered this mess. But being short an asset that rises in value happens every day in the world of money management, leaving the explanation for the magnitude of the losses incomplete. We’ll have to stay tuned for when insiders give true autopsies of these cadaverous positions.

For now, what are the main takeaways?

To start, one critical point: These billion dollar funds did not lose a billion dollars of their investors’ money. Reportedly, COMAC’s Swissy trade cost the fund about 8% and all-in the fund was down around 10% in the year so far. (Why, then, they shut down I’ll get to in a moment.) It’s important to not overstate the extent of the real economic damage delivered to shareholders in these funds.

That said, I’m struck by two other things in this mini-debacle. First, how bad does a fund’s risk management program have to be in order to sustain such big losses due to one wager? (This is a rhetorical question.)

The nature of this particular trade, one which is shaped by explicit political intervention by the SNB, and why top macro traders would get burned by it, is a head scratcher. 

From a technical risk management point of view, betting on the CHF would likely count as a “low risk” trade because there is so little volatility in the currency. A standard quantitative risk tool, as well as a human being comparing low volatility to high volatility assets, would conclude that with sufficient historical evidence, the asset with a record of smooth performance would be less likely to jump around, either up or down.

But that begs the question of why the asset in this scenario has a low volatility profile. The answer, obviously, is tied to the SNB’s currency control, meaning that an in-demand currency with an artificial ceiling on its value will likely skate along that cap value with few perturbations.

So this begs another question, apparently the only one that really matters: What’s the likelihood that the SNB lifts the ceiling? It’s not zero. The big problem here is that it’s hard to assign a probability to this event and then just as hard to estimate how much the currency would move if the cap were lifted.

What does this suggest to any good risk manager? If you want to take the view that the CHF will decline, that’s fine, but don’t bet big. There’s too much that’s unquantifiable—and unknowable—about a situation convoluted by the politics of currency manipulation. What appears to be the case is that these now-defunct funds did indeed take this view in great size, probably through the embedded leverage that exists in some of the derivatives structures one needs to make currency bets.

So to answer my own rhetorical question above: This is just terrible risk management.

The second observation is that the closures reveal something unpleasant about the world of traders who are largely compensated by an incentive fee, meaning that they get to keep a percentage of the profits they generate from their trades. The standard incentive fee is 20%, so the crude math is that a $1 billion fund that makes 15% in a year will have grown by $150 million, of which the portfolio management team keeps $30 million.

The rub is that those privileged enough to earn an incentive fee typically have to abide by a “high water mark,” meaning that if the fund loses money it not only collects zero incentive fee, it has to climb back to scratch in order to start collecting those fees again. In this proper alignment of interests, the fund has to make back all of your money before it can start earning this form of profits again.

But there’s a wrinkle. There is the perverse possibility that if a fund loses enough such that recovering the losses seems improbable, the portfolio manager can just shut down the fund and return the balance of the investors’ capital. They can then move on to their next venture, if the personal reputational damage of doing this isn’t too severe. (Or if you’ve made more than enough, just bow out. Reportedly, there’s about $150 million of “inside capital” that we can surmise is mostly O’Shea’s nest egg which he will continue to trade privately under the COMAC umbrella.)

This is one version of the “trader’s option,” an unsavory element of the money business in which portfolio managers have incentives to bet bigger than they might otherwise insofar as there is an asymmetric payoff to such positions. Where the potential upside is much higher than the downside, there is an incentive to go all-in.

Unfortunately, the lessons for investors that stem from this situation are not profound. If anything, do whatever due diligence is necessary to understand that the portfolio managers have whatever resources (including common sense) are necessary to avoid singularly large bets which can produce catastrophic losses or destabilize the business. For better or worse, however, it’s highly likely that the shops mentioned above did have those resources, as all are brand names in the industry. Ultimately, perhaps, there’s a caveat emptor to ponder: for those looking to meaningfully outperform the markets or do something different from the pack, appreciate that that decision is a risky one, too, and should not be taken lightly.

Past performance is not a guarantee of future results.

Virtus Investment Partners provides this communication as a matter of general information. The opinions stated herein are those of the author and not necessarily the opinions of Virtus, its affiliates or its subadvisers. Portfolio managers at Virtus make investment decisions in accordance with specific client guidelines and restrictions. As a result, client accounts may differ in strategy and composition from the information presented herein. Any facts and statistics quoted are from sources believed to be reliable, but they may be incomplete or condensed and we do not guarantee their accuracy. This communication is not an offer or solicitation to purchase or sell any security, and it is not a research report. Individuals should consult with a qualified financial professional before making any investment decisions.