How the hedge fund industry can maximise returns in 2019

2018 saw record losses for the hedge fund industry, so we have put together our top tips to ensure 2019 can be a success

How the hedge fund industry can maximise returns in 2019
15th February 2019 Peter Rippon

2018 was a year the hedge fund industry would rather forget.

The community recorded a loss of 5.7% according to the Bloomberg Hedge Fund database – making it the industry’s worst performing year since 2011 – and HSBC’s investment group revealed that only 16 hedge funds out of the 450 monitored delivered positive returns before fees.

The reasons?

Mainly, political risk and trade tensions have led to an unpredictable and highly volatile trading environment. While this presents new opportunities to Fixed Income Macro and Relative Value strategies, it hurt all other types of fund in 2018.

$15bn left the industry in November and, although this sounds like a drop in the ocean for managers, the accelerated rate in which investors are pulling funds is something to worry about.

This year, managers will still be faced with the same hurdles, but on top of mounting industry regulation.

So with increased capital requirements, how can managers reduce margin to ensure 2019 is a success?

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Get ahead of upcoming regulation.

The 2008 financial crisis resulted in the implementation of stricter regulation, which is only impacting the majority of the hedge fund industry now.

These rules include margin requirements for non-centrally cleared derivatives. While most funds have been clearing derivatives for years and posting collateral on their bilateral transactions, non-cleared regulation is about to take capital requirements to a whole new level.

Mandatory Uncleared Margin rules (otherwise known as UMR) are due to capture over 2,000 buy-side firms by September 2019 and 2020. This regulation means derivatives are instantly deleveraged as more margin has to be posted on every single trade, tying up essential funds that could be used to generate returns elsewhere.

Making fund managers post more cash sounds great in principle. But in practice, these rules trigger a massive cost for the industry, which ultimately, will be shouldered by the very end investors that regulators are trying to protect.

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The impact on the entire hedge fund industry is dramatic: the US treasury has predicted over $2 trillion additional margin will be posted by 2020. Pre-crisis you could determine what market view you wanted to take and just trade without thinking but, doing that today, you could very easily deploy 50% more capital in the form of margin.

Consequently, upcoming UMR rules will force managers to think more about capital allocation. For highly levered strategies, posting margin under UMR means that a recapitalisation of the fund may be required for portfolio managers to continue to trade in the same size. This comes at a time of increased investor scrutiny, with unencumbered cash levels being one of the areas of focus, so it’s important to get your head round upcoming changes and how to adapt your trading practices sooner rather than later.

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Focus on reducing your margin.

One of the easiest ways to do this is to reduce the margin you’re paying today for the same amount of risk; so you need to really understand the ways in which margin is calculated.

For CCPs to cover liquidity and concentration risk, they need to charge additional margin, especially for large positions. But the margin charged by different CCPs for the same products can vary by surprisingly large amounts, particularly considering they cover the same risks. For instance, margin rates can differ as much as 50%.

Identifying the optimal way to express and allocate risk can therefore have a dramatic impact on capital requirements. Our analysis shows that moving up to 10 positions between clearing brokers can lead to a 25% reduction in initial margin. That equates to hundreds of millions of dollars released, available then to scale up positions.

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The clearing landscape is highly sophisticated, and it is becoming harder and harder for hedge funds to know the drivers of margin beyond what is reported by their brokers.

At a time when investors are scrutinising every penny, the last thing any fund manager needs is to be posting more margin than is necessary. For this reason, the number of firms turning to in-depth analysis, seeking out opportunities to reduce their margin, has risen substantially.

By taking measures like this, factoring capital into trading, treasury and operational decisions, funds can save hundreds of millions of dollars. That extra capital can then be deployed elsewhere, generating further returns and improving the liquidity profiles of funds.

If firms learn early on how to best manage new regulation, 2019 does have the true potential to be a brighter year for the hedge fund industry.