Last updated: May 7, 2009 12:46 pm

Be careful what you ask for with hedge funds

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Is there light at the end of the tunnel for the beleaguered hedge fund industry?

Investors in a once-seemingly bulletproof sector were presented with a barrage of nasty surprises last year. The 20 per cent industry-wide losses from an asset class supposed to produce absolute returns were bad enough. The myriad of suspensions and gates that trapped cash fleeing for the exits and the lack of due diligence provided by some fund of funds, as exposed by the Madoff debacle, were worse still.

Despite the range of inventive restrictions dreamt up by the ever-fertile minds of the hedge fund industry, investors did manage to withdraw a net $154bn (£104bn, €118bn) last year, according to HFR, which, combined with tumbling asset prices, reduced the size of the industry from $1,870bn to $1,410bn.

But, lo, hark the hedge fund angels sing. According to EurekaHedge, some 96 per cent of all hedge funds that form its indices outperformed the MSCI World index in the first quarter of 2009.

Admittedly the fact that this particular equity index slumped 12.5 per cent in the first quarter does take more than a little gloss off this achievement. But, nevertheless, there are other tentative signs that the hedgies may have been reminded that their role in life is to make cash-plus absolute returns, not take the sort of leveraged bets on mainstream assets that any fool could construct.

Credit Suisse/Tremont says the average hedge fund eked out a gain of 0.85 per cent in the first quarter of 2009, while HFR puts this figure at a more miserly 0.52 per cent. These numbers are unlikely to get the investment community breaking down the door to hand over their readies, but at least they do suggest that at least one side of the hedgies’ business has stabilised.

The harder part is persuading bruised investors to re-enter the fray. Given the swathe of gates and suspensions in place, it seems likely that cash investors attempted to withdraw last autumn will continue to trickle out for the next few months.

Indeed, this process may be exacerbated by the success some funds appear to have had in extricating themselves from illiquid positions more quickly than they anticipated, allowing money to flee ahead of schedule.

A welter of recent surveys have indicated that institutions’ long-term appetite for hedge funds has not been diminished by the events of the past year.

Yet few are predicting an imminent rush. Standard & Poor’s stuck its neck out last week, in relative terms at least, when it tentatively suggested fund of funds “could soon” start to see renewed inflows.

But less racy commentators believe it will be 2010 before cash starts to flow again, always assuming there are no more major scares in the meantime.

But what sort of world may be awaiting investors if and when they do return?

Dan Goldman, chief executive of Chicago-based Ketch Capital Management, paints an intriguing picture of an industry caught between huge downward pressure on fees and ineluctably rising regulatory and administrative costs.

One consequence of these pressures, he believes, will be a wave of consolidation, with 20-30 hedge funds that are whiter than white emerging to take control of 80 per cent plus of industry assets. These funds would tick every regulatory box going but, performance-wise, are likely to be as dull as ditchwater.

However, with fees falling and costs rising, risk-takers will increasingly decide that managing external capital does not make sense, Mr Goldman believes.

The result will be an increasing number of proprietary shops, arcades and partnerships, which can skip the costs of building a fully regulated, all-singing, all-dancing hedge fund, and be far more nimble than their lumbering rivals to boot. Pension funds, endowments and family offices large enough to employ their own portfolio managers will scoop up some of these displaced hedge fund managers for themselves.

But for everyone else it may prove to be a case of being careful what you ask for.

Investors and regulators are rightly demanding hedge funds clean up their act. The result may be a world where investors of more limited means are locked out of any excess returns the asset class is genuinely able to produce.

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