“Our research dialogue with hedge fund managers is confirming the observation Hennessee Group made to its clients earlier this year,” remarked Charles Gradante, Managing Principal of Hennessee Group LLC.

He added:

“Then and now, we can continue to be concerned about hedge funds who are writing and issuing credit default swaps without owning the underlying bond, for the sole purpose of increasing performance.”

A credit default swap is a specific kind of counterparty agreement which allows the transfer of third party credit risk from one party to the other. One party in the swap is a lender and faces credit risk from a third party, and the counterparty in the credit default swap agrees to insure this risk in exchange for regular periodic payments.

However, through over reliance on these instruments, Grandate believes the industry may be storing problems up for the future.

“If we have a credit event, several hedge funds may face systemic portfolio problems,” he warned.

“We are not only seeing this trade among credit arbitrage managers, but also among equity hedge fund managers who recognize the risk of naked put writing, but are confident in the credit risk,” he observed.

Hedge funds produced a positive return of 2.75% in November according to Hennessee, bringing year to date returns to a shade under 6%.

The Hennessee Regulation D, Latin American and Pacific Rim indices were notable contributors to last month’s performance, whilst short sellers suffered losses of 9%.