The FT has today published an insightful article on what it calls the "shadow banking" system - the world of special purpose vehicles such as SIV's, asset backed commerical paper conduits, CDO's, CBO's and the multitude of other acronyms.
Bill Gross of PIMCO summarises the situation today: “What we are witnessing is essentially the breakdown of our modern-day banking system, a complex of leveraged lending [that is] so hard to understand...Colleagues call it the ‘shadow banking system’ because it has lain hidden for years, untouched by regulation yet free to magically and mystically create and then package subprime loans in [ways] that only Wall Street wizards could explain."
How does this impact the hedge fund industry? Clearly, hedge funds and the shadow banking system (sounds suspiciously like the shadow economy!) are interlinked. The growth of alternative asset capital - and the need to invest it somewhere - has been a material driver to the growth of structured products in recent years.
As we think about structured investments, ever more complex derivatives and their use by hedge funds, It strikes us that the hedge fund industry has gone through three phases:
- The beginning of the world through 1998: this was the world of the hedge fund pioneers. Until, of course, everything came to a screeching halt with LTCM. The parallels to today's markets are obvious - math, doctorates (nobel prizes!) and the dogma of "rational economic decision making" may well be smarter than the markets - most of the time.
- 1998 to 2000: the tech bubble, where everyone trading long / short TMT and biotech was going to make a killing.
- The market since 2000 or, more particularly, the markets since the bottom in 2002. The defining feature of this period, in our mind, is financial engineering, which gets to exactly the same point as the FT article.
Until 2002, the majority of hedge funds we reviewed were long / short equity, and $750 million was a large firm. Now, long / short equity has become proportionately less important as new funds attack complex, structured (and usually levered) investment strategies. It's also the case that $750 million is now the amount of money a good fund can raise in a month.
How times change.