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The safest hedged portfolio would do no better than cash. Its perfect balancing of risks would earn nothing. That reality did not stop Allianz Global Investors, an offshoot of Europe’s largest insurer, from coming unstuck after offering supposedly protected returns.
Tempestuous markets in early 2020 damaged its US Structured Alpha Funds, triggering client lawsuits and now an investigation by the US Department of Justice.
The tale is a cautionary one, as a 6 per cent drop in Allianz shares on Monday indicated. But it will not stop alternative asset managers, prime brokers and corporate finance directors from claiming “we are fully hedged” when they are no such thing.
Allianz Global funds were supposed to produce positive returns regardless of market volatility. An investment strategy of selling volatility using options failed when all asset prices collapsed. One fund, the Alpha 750, shed three-quarters of its value in the first three months of last year.
Protection strategies tend to fall apart when the correlation between the main asset and its hedge does the same. This is particularly likely to happen under extreme market stress.
Good specialist hedge funds plan for such times. Big long fund managers are less likely to do so. Munich-based Allianz was apparently covering so-called “tail risk” with cheap derivatives, increasing the chances of mismatches.
A cynic would also point out that when a private hedge fund is hammered by markets it can simply wind itself up, imposing losses on clients. Failed hedge funds embedded in big quoted financial groups may transfer liabilities to these parents instead.
The patchy fortunes of hedge funds explain why top names such as Third Point and Marshall Wace want to invest more in unlisted companies. Private equity and debt managers have grown far more impressively. Private capital assets have more than tripled to $7.4tn since 2010, according to Morgan Stanley — well ahead of the total for hedge funds.
Hedges that cover big chunks of market risk are expensive and do not always work. Better, perhaps, to get out of public markets altogether.
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