Hedge Funds Facing Capacity Problems

by Carla Johnson, Investors Offshore.com, London

21 November 2001

The International Herald Tribune reports that many of the best hedge funds have closed to new investors, fearful that their strategies, which have generated returns of 15% to 30%, are not scalable beyond current levels of capital. This is true for convertible bond arbitrage, for example, in which funds have recently been very successful, but are dependent on the supply of suitable bonds.

In convertible bond arbitrage a fund manager buys a convertible bond, a bond that can be "converted" into a stock if the underlying share price rises. At the same time, the manager sells short the underlying stock - hedging against a price decline. Because the bond will retain some of its value even if the stock price falls, the hedge fund should be able to profit from any volatility in prices. The popularity of this strategy has contributed to a record level of convertible bond issuance this year, but there are limits to demand and they are now being reached.

Tim Bell, who is in charge of hedge funds at UBS Warburg private banking, told the newspaper that many so-called multistrategy arbitrage funds, which have also posted high this year, have closed themselves to new investors. Some are even turning down additional money from existing investors. "The ability of arbitrageurs to put their money to work has declined," Mr. Bell said. "There's more capital chasing fewer opportunities." But the upside, he says, is that with more capital available from investors, hedge funds need to use less debt to leverage their positions. That means lower risk.

Despite the problems, new funds continue to spring up to take advantage of investors' eagerness: yesterday saw the launch of the hopefully entitled Stellar Fund, which is incorporated in Guernsey and will be listed on the Irish Stock Exchange, will invest in corporates, emerging markets and government debt. South African group Liberty Ermitage has invested $25m, and it is expected that the fund will raise about $35m.

Stellar is targeting a return of 10% to 15%, and will concentrate on B-rated bonds, although it has the capacity to maintain its holdings if the rating of an investment is slashed to triple C - which is defined as junk.

Fund manager Paul Brain said: "We believe that a diversified portfolio of high-yielding assets can produce the opportunity for excellent absolute returns and, importantly, that the volatility of these returns can be managed by use of government securities."

He said the team has spent the past 10 months refining investment models and maintaining a dummy portfolio which had "performed extremely well".

Mr Brain added that the timing was "perfect for Stellar as the recent global economic slowdown has resulted in an increased supply of government and corporate bonds, and there is more opportunity to identify mispricings of credit and changing trends in sectors and markets."

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