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Hedge Fund Investors Take the Naked Volatility Test

Hedge Fund Investors Take the Naked Volatility Test

(Bloomberg Opinion) -- It’s only when the tide goes out that you find out who’s been swimming naked, the billionaire investor Warren Buffett famously opined. After the violent moves in stocks and bonds this week, H20 Asset Management’s traders need to keep hold of their Speedos.

The firm, run by Bruno Crastes and Vincent Chailley and backed by French bank Natixis SA, saw its funds hammered by losses as stocks, oil and Italian bonds slumped on Monday. Its Multiequities fund declined by about 30% in a single day and erased six years of gains, while its Multibonds strategy lost 20%, as my colleagues at Bloomberg News reported on Wednesday.

H20, which managed $34 billion at the end of last year, appears to have loaded up on wrong-way bets at exactly the wrong time. In a note to investors dated March 3 about its February performance, the fund manager said it had sold short-term volatility across U.S. and European equity markets; on Monday, the VIX index of U.S. equity volatility surged 30%.

The fund had also increased its exposure to Italian government debt; on Monday, 10-year Italian yields surged 35 basis points to a two-month high of 1.44%. And its portfolios were long of oil —  which plunged 25% on the first trading day of this week for its biggest price drop since the 1991 Gulf War.

But this is exactly how hedge funds should behave. They’re supposed to be at the cutting edge of finance, taking risky bets on the trades they back and piling on the leverage when they sniff out a high-conviction profit opportunity. Otherwise, they’re just like any other mutual fund, albeit charging much higher fees.

In 1992, for example, George Soros, arguably the most famous hedge fund manager of all time, made more than $1 billion for his Quantum Fund by betting on a break of the currency peg that the British authorities were defending between the pound and the currencies that would ultimately be subsumed into the euro. His gains, though, were amplified by his willingness to back what he saw as a winning trade.

“Shorting the pound was Stanley Druckenmiller's idea; Soros's contribution was pushing him to take a gigantic position,” Scott Bessent, who was then running Soros's London office, told author Steve Drobny for his 2006 book “Inside the House of Money.” As Bessent explained, “George used to say,`If you're right in a position, you can never be big enough.’”

Of course, when you’re wrong, it can backfire big time – as H20’s investors are learning.

H20 has made no secret of its use of leverage in its pursuit of outsize returns which, by and large, has been a successful strategy in recent years. Its Multibonds fund, for example, has delivered a five-year return of more than 94%, compared with the 17% from the JPMorgan Chase & Co. benchmark against which its performance is measured, according to the H20 website. That’s quite a remarkable degree of outperformance — the kind of index-beating return that hedge funds claim to be able to supply to customers.  

Last June, after the Financial Times reported that H20 had loaded up on illiquid debt sold by German entrepreneur Lars Windhorst, Morningstar Inc. suspended the rating on one of its flagship funds. Investors responded by withdrawing almost 8 billion euros ($9 billion) from the firm in a month. Crastes and Chailley responded by delivering a masterclass in disaster management, featuring a robust video explanation of their rationale for making those investments.

We’ll have to see whether H20’s clients are willing to stick with the firm during its current turbulent times. If they’re not, they might want to consider why they invested in a hedge fund in the first place.

To contact the editor responsible for this story: Melissa Pozsgay at mpozsgay@bloomberg.net

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Mark Gilbert is a Bloomberg Opinion columnist covering asset management. He previously was the London bureau chief for Bloomberg News. He is also the author of "Complicit: How Greed and Collusion Made the Credit Crisis Unstoppable."

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