The current environment
2021 was an unprecedented year for market performance, where broad-based indices across major markets outperformed long-term averages. Heightened volatility observed in 2020 subsided with the VIX reverting to its long-term average. The US Large Cap, Mid Cap, and Small Cap benchmarks returned between 23-27%.
Source: https://www.spglobal.com/spdji/en/commentary/article/us-equities-market-attributes-december-2021
Hedge Fund performance varied across styles. Quant funds emerged from the Quant winter outperforming the broader market; some of the larger well-established Macro funds were wrong-footed by early trades on interest rates where central banks had been slow to react to inflationary pressures on the markets. Altogether, according to HFR, the hedge fund industry gained 10.3% on average — a significant underperformance at industry level. Simultaneously, the top 20 hedge funds returned $65.4 Billion for investors, the largest annual gain on record while the larger multi-manager funds returned more than 25%.
The start of 2022 was marked by higher volatility, a rising rate environment, and increasing energy prices: a trend which is predicted to continue into the second half of the year These factors, coupled with geopolitical risk, have all impacted the broader markets, with the major US indices heading into correction territory. Additionally, the lockdown stocks, high-growth tech stocks, and sectors with exposure to Russia have all taken a significant hit in their performance.
A challenging start to 2022, combined with this year’s increased volatility, has reinvigorated the focus around costs and constraints on hedge fund strategies as a means of ensuring any hard-fought market gains are not lost due to an unexpected or poorly understood drag on performance.
Hedge Fund Costs and Constraints
Margin requirements are invariably the overarching constraint to hedge fund businesses. In volatile markets, significant moves in Initial Margin may cause funds to be required to de-lever, forcing them to liquidate positions at potentially stressed prices. This is clearly suboptimal and triggers unnecessary costs to business.
The need to understand margin requirements is intensified in the Prime Brokerage world. Recent industry events such as DB, CS exiting PB, and Archegos’ collapsing have all driven an increased emphasis on PB Margin models. The focus has largely been on understanding how their Prime Broker brokers are charging margin under bespoke house models, stress scenarios, exchange, and reg models. For fund managers and execution traders, increasing transparency allows them to make informed decisions when modelling and executing trades.
Front office users are actively shaping their workflows to know at the time of trading not only the forward-looking margin impact but also the comparison of the lowest margin across all available trading routes.
In addition to understanding today’s margin requirements, the more levered funds, which traditionally hold fewer excess cash reserves, are looking for ways to ensure they have optimal buffers of unencumbered cash to meet margin spikes arising from choppy markets. Being able to forecast IM and VM, under both normal and stressed market conditions, can ensure these hedge funds are not forced into fire sales.
Ensuring collateral resilience in times of market duress is the first step towards a truly optimized treasury function for hedge funds. The ability to forecast initial margin under client-defined stress scenarios allows companies to optimize in-house collateral inventory, ensuring the lowest possible funding costs and freeing up excess assets which can be optimized across revenue sources such as Repo and SBL to enhance fund performance.
Another key concern raised by hedge funds is the upcoming Phase 6 UMR Regulation. With the recent annual margin survey produced by ISDA it is unsurprising to see the nearly 40% increase in Reg IM and House IA collected by phase 6 firms. The Regulatory IM increase was expected and is the major driver with many firms in scope for phase 5. Notably, the amount collected by Phase One dealer banks shows a marked increase in House IA, with the number standing at 82.5 billion USD.
Considering the lower phase-in threshold, a much larger number (upwards of 700) of buy-side firms are expected to be subject to Regulatory IM from September this year. Coupled with the elevated market volatility, this number is expected to balloon up in the coming year.
One interesting take away from the ISDA survey is the composition of collateral that is posted, with the house IA element accounting for a mix of 43.8% Cash, 17.9% in government securities and 38.2% in other securities. In contrast, Reg IM only has 5.5% cash, with majority of 73.6% in government securities and remaining 20.9% other securities. The eligibility schedules for Reg IM are much stricter and require complete segregation, i.e., collateral can’t be rehypothecated or reused to enhance yield. Again, optimizing collateral inventory across revenue sources helps to ensure resiliency and maintain optimal buffers.
The use of flexible margin attribution tools helps to ensure that hedge funds have a complete view of the true profitability across their fund managers and strategies by assigning the cost of margin to each strategy individually to determine drivers of cost and margin.
This is especially prevalent in funds with multi-manager strategies: they actively look to proportionally allocate fund level margin down to portfolio managers and underlying strategies. A growing number of our client base is now enhancing this functionality to understand the netting benefit that individual managers have to the overall fund by looking at the closeout impact that these strategies have.
Within this current climate of market volatility, companies are on the lookout for technological solutions that will help them manage market risk, reduce costs and increase efficiency. When instability becomes the norm, as it has been for the past few years, it becomes even more important for companies to both streamline and reinforce their workflows to avoid diminishing their market gains.
Cassini’s unique margin analytics platform provides hedge funds with the ability to increase operational alpha through the trade lifecycle without the operational burden of setting up an in-house treasury fund. Through the application of this system, companies can overcome today’s market volatility and, in spite of the current climate, continue to manage risk and grow beyond their current scope.
Resources/References
https://www.ft.com/content/ac871bc8-f713-4cb8-9a90-0a415b094b78
https://www.ft.com/content/4ad68f4b-fce9-4ef5-9c6a-fdf838145200
https://www.ft.com/content/7332ed23-d707-41c1-813b-c9d659697348
Ignoring climate risk helps Crispin Odey hedge fund jump 30% – Risk.net
