Hedge Fund Titan Warns UK Pension Crisis Is Just the Start

(Bloomberg) — For one of the world’s largest hedge funds, the UK pension fund crisis is just starting as central banks around the world raise interest rates and turn off quantitative easing.

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Paul Marshall, co-founder of $62 billion investment firm Marshall Wace, said central banks had created the perfect environment for “mal-investment’ by artificially holding interest rates low for years.

“The UK LDI industry is the first casualty of the end of the ‘money for nothing’ era — the first dead fish to float to the surface as rising central bank interest rates act like dynamite fishing in global asset markets,” Marshall said in a letter sent to clients this month.

So-called liability-driven investments are a form of financial engineering that involve derivatives and allow defined benefit pension schemes to jack up leverage and juice returns. The Bank of England was forced to step in to stabilize markets after rising gilt yields triggered margin calls at the funds that came too quickly for them to manage.

JPMorgan Chase & Co. estimates the losses from so-called liability-driven investments deployed by pension schemes has grown to as much as £150 billion ($171 billion) since early August.

The pensions were acting like hedge fund managers with much less knowledge or nimbleness, Marshall said in the letter.

Crispin Odey, the British hedge fund manager who has profited this year from short wagers on gilts, warned the LDI crisis is only just beginning.

“LDI investors are forced to sell to pay for their losses and it does not look like it will stop,” Odey wrote in a letter sent to investors this month.

Representatives for Marshall and Odey declined to comment.

“Everyone wanted to blame the new Chancellor, Kwasi Kwarteng, for the melt down,” Odey said, referring to the former UK chancellor who stepped down from the role last week. “But I believe it was really 20 years in the creation and brought about by the unstoppable rise in prices,” Odey said.

Marshall said people won’t all agree on who should take the blame for the crisis.

“We can argue how much of the collapse in the UK gilt market was due to the timidity of the Bank of England on interest rates, how much due to Kwasi Kwarteng’s budget and how much due to the distress in the LDI industry,” he wrote.

Central banks reversing years of quantitative easing to contain spiraling inflation have induced volatility and roiled stock, bonds and currency markets. The UK government under a new chancellor has now reversed tax cuts it announced last month that sparked a sell-off in gilts and exposed the weakness in the LDI structures.

Next in line could be the European sovereign bond markets, Marshall said. The billionaire also flagged the risk of central banks pausing their tightening process given the fragility of the financial system.

“The painful path will bring casualties and it will be interesting to see how central banks react when these casualties float to the surface,” Marshall wrote. “Time will tell. But for the moment, we believe the best opportunities remain in the short side,” he said referring to a strategy that makes money from falling prices.

Marshall Wace’s flagship Eureka hedge fund is up 4.2% this year. Odey Asset Management’s Odey European Inc. hedge fund has returned a record 193% through September this year.