Hedge funds maze

As hedge fund managers returned last week to their plush offices in London’s Mayfair and Greenwich, Connecticut, many hoped to forget the industry’s worst year on record. But 2009 threatens to bring a detox diet for traders previously held up as among the world’s best – thinning the industry’s ranks and putting in jeopardy the fat fees that turned many “hedgies” into billionaires.

Dismal returns and investor panic are in danger of proving fatal for many funds, following the worst year since Chicago’s Hedge Fund Research started tracking returns in 1980. Losses reached 18.3 per cent as record numbers of funds closed and investors pulled tens of billions of dollars, even from those that made profits.

If that were not bad enough, the image of the industry was further tarnished by Bernard Madoff’s alleged $50bn (£33bn, €37bn) fraud – adding to demands from watchdogs and politicians around the world for tougher regulation.

Regulators added to hedge funds’ troubles last year with temporary bans on short selling – betting against shares – in financial companies after the September collapse of Lehman Brothers in the US.

Banks, meanwhile, withdrew the cheap loans that fuelled the boom of the past decade and are demanding that funds post more “margin”, or collateral, against some of the most troubled investments, using up cash at the worst possible time.

On top of that, investors who want to stick with hedge funds are insisting on better terms in return for their loyalty: lower fees as well as greater transparency and independent oversight.

The final item in this litany of fund managers’ woes is the overhang of hundreds of billions of dollars shares, bonds and other assets waiting to be sold by funds that have suspended or restricted withdrawals. There are no hard numbers, but Switzerland’s Union Bancaire Privée, the biggest allocator of money to hedge funds, estimates that managers handling as much as half the industry’s $1,560bn in investments have imposed some sort of withdrawal restriction.

“Everyone has been discredited,” says one hedge fund manager who shut down last year. “Even all these guys who were big and supposed to be fabulous risk managers are discredited.”

Huw van Steenis, analyst at Morgan Stanley, says the cost of borrowing will also hurt future returns. This is going to be grisly,” he adds. “Strategies are going to be much less highly levered, which alongside borrowing costs are likely to trim returns for many.”

Since no one knows for sure how many hedge funds there are, it is hard to make firm forecasts of what will happen to them. But predictions are dire. Strategists at Barclays Capital say that 70-80 per cent of funds will shut, while Morgan Stanley predicts that industry assets will halve from their peak by the end of March.

George Soros, the billionaire hedge fund manager who became infamous for forcing the pound out of Europe’s exchange rate mechanism in 1992, told the US Congress in November that hedge funds would shrink by 50-75 per cent from their $2,000bn or so peak. “During the current financial crisis, many hedge fund managers forgot the cardinal rule of hedge fund investing, which is to protect investor capital during down markets,” Mr Soros said.

The shake-out is not just bad news for the yacht brokers, art dealers and luxury car salesmen who have helped hedgies dispose of their profits in recent years. There are wider consequences too. Hedge funds had become key allocators of capital, with a willingness to take risks in deciding which companies, industries and countries to back. Apart from helping companies raise cash, they provide liquidity to the markets and make those markets more efficient by arbitraging away price differences.

So their battering has also hit equity and debt markets, creating a spiral of selling that brought margin calls by banks, in turn prompting more forced selling and margin calls for otherwise healthy funds. Now, according to analysts, the hangover of suspended or restricted funds could keep markets depressed, especially those in which hedge funds were the main participants, such as bonds convertible into equity.

Yet many see what is happening as a necessary part of the raw Darwinism that regularly kills off the weakest in the industry. Indeed, some of the world’s top prime brokers, hedge fund managers and investors argue that 2009 could be a year of booming returns for the remaining funds. “For the guys who survive, the spoils are usually great,” says Crispin Odey, founder of London’s Odey Asset Management, whose fund was up 42.5 per cent in dollar terms last year.

Some even argue that last year’s losses will make hedge funds appear attractive relative to declines of 40-50 per cent for investors’ equity portfolios. That is a far cry from hedge funds’ traditional marketing pitch of “absolute returns” whatever happens to markets.

Hedge funds

“Performance was disappointing,” says Christopher Fawcett, co-founder of Fauchier Partners, a London fund of hedge funds, and former chairman of the Alternative Investment Management Association, an industry grouping. “But given the specific difficulties hedge funds faced last year – rapidly changing rules on collateral, a major prime broker going bust and regulators changing the rules on short selling in the middle of the match – their returns were more understandable.”

He says some pension funds and other institutional investors are adding to hedge fund holdings, spotting an investment opportunity.

The industry, though, will look very different by the end of the year. Strategies dependent on borrowing are dead in the water, thanks to banks’ unwillingness to lend and soaring borrowing costs. So-called relative value trading approaches, which rely on arbitraging prices expected to converge, using heavy leverage to turn small price movements into big profits, have been sunk.

From convertible bond arbitrage through Japanese government bond futures to credit derivatives, funds relying on this approach have seen heavy losses, with many going out of business and others suspending withdrawals. In the debt markets, hedge funds have also been slaughtered as leveraged bets turned sour.

“When the dust settles, people will start investing in hedge funds again but there will be a new order,” says Ken Kinsey-Quick, who oversees hedge fund portfolios for Thames River Capital in London. He, like many, predicts that the industry will bifurcate into funds specialising in hard-to-trade strategies such as credit and distressed debt, with long lock-ins for investors and fees charged only once profits are realised; and a bigger section of funds with liquid strategies, including equities and managed futures, which will better match the withdrawal wishes of their investors.

Paul Tudor Jones, the legendary trader who runs Tudor Investment Corp, says he is going “back to the future”, reverting to trading the easy-to-sell assets he stuck to in the 1980s. Citadel and Fortress Investment Group’s Drawbridge are making similar moves to easier-to-understand liquid strategies.

The terms of trade for hedge funds are set to alter radically, though. Investors are demanding, and in many cases getting, a new deal on fees. Some funds, reportedly including some from Citadel and one from Renaissance Technologies, two of the biggest US managers, have waived management fees after poor performance.

“Two and 20 [2 per cent a year and 20 per cent of profits] is no more for most funds,” says one big hedge fund investor, referring to the industry standard fee structure. “New funds will have to give us a better deal, although the successful guys don’t have to, so they won’t.”

The way survival of the fittest works in the hedge fund industry is, however, as chaotic as the operation of Darwinism in nature. Consider Peloton Partners. The London-based hedge fund was the most spectacular collapse of last year, losing $2bn in a week in February as its flagship fund collapsed after betting the wrong way on US mortgage securities.

Geoff Grant, the California-based co-founder and chief investment officer, succeeded in September in raising $130m for a new fund, including close to $100m from France’s Société Générale, according to people familiar with the plan. In the evolution of the fund, it will invest only in easy-to-trade instruments, avoiding the liquidity problems that contributed to Peloton’s failure.

GLC, a $1bn hedge fund ensconced in Peloton’s old offices in the former Ford design studio in London’s Soho, is finding evolution is not working in the way it expected. All GLC’s funds – run by computers trading futures or using statistics to arbitrage equities – made money last year and its flagship multi-strategy fund rose by one-quarter. But instead of investors switching to GLC, close to one-third of its money has been taken out, says Lawrence Staden, one of the founders of the company in 1992.

“You would think the money would be pouring in but we have seen redemptions across the board,” he says. “The reason is we are one of the funds that stayed open – we are an ATM for the hedge fund industry.”

The same story is being played out at other big funds that refused to impose restrictions on withdrawals, such as London’s Marshall Wace and New York’s Cantillon Capital Management, both of which have seen billions of dollars of withdrawals. “The bet that some of these guys are going to have to take is that keeping the high moral ground [and paying out withdrawals] means no business,” says the head of prime brokerage at one leading bank.

While holding on to customers is proving hard, keeping staff presents a tougher task for the bulk of funds that have performed badly. Analysts, investment bankers, economists and even weather forecasters have been attracted to hedge funds by the hope of handsome bonuses.

But bountiful pay cheques were made possible by the fees hedge funds charged. Investors suspect many more hedge fund partners will simply pack it in and go skiing because they expect little in the way of bonuses for years.

“In the old days it used to be very hard to get capital and very easy to make money,” says GLC’s Mr Staden. “Recently it became very easy to get capital and very hard to make money. We are going back to a time when capital is scarce but it is easy to get returns – though that doesn’t help you if you go out of business before the assets come back into the industry.”

MARKET MOVERS: WANING INFLUENCE ON VALUATIONS

Hedge funds may operate in the shadows but their effect on markets last year was startlingly clear.

In particular, the market in bonds convertible into equity all but closed after highly-geared hedge funds and proprietary trading desks, their brethren within investment banks, dumped the bonds to meet tighter lending standards and comply with a brief US ban on short-selling.

Between them, funds and prop traders made up most of the market, where they provided a backstop source of financing for companies.

Equities also suffered from the funds’ retreat. Research by Goldman Sachs shows that those shares with big hedge fund holdings fell far faster last autumn than others as the funds acted to raise cash.

Barry Bausano of Deutsche Bank estimates hedge funds controlled more than $10,000bn (£6,600bn, €7,450bn) of investments at their peak last year, thanks to borrowings of five to six times their net assets. This was about one-fifth of the market value of the world’s listed companies a year ago – although much was invested in bonds or derivatives or used to bet against, or short, shares.

Mr Bausano estimates that borrowing, including short positions, is now down to two to three times net assets, with some saying it is even lower. That means thousands of billions of dollars have come out of equities, bonds and derivatives because of hedge fund actions alone.

This sheer size made hedge funds key to the valuations of virtually everything. As they unwound positions during the year, assets as diverse as Japanese government bonds, US mortgage securities and shares in Volkswagen saw previously unheard-of moves.

Gone now is much of the hedge funds’ power in the market – and the price for companies and markets has arguably been heavy.

● For investors with long memories, the hedge fund crisis of 2008 was déjà vu.

Back in 1994, a dire performance by Michael Steinhardt prompted warnings that the industry was in trouble, with the hedge fund manager – one of the world’s best-known traders – shutting up shop the following year.

Four years later the rescue of Long Term Capital Management organised by the New York Federal Reserve prompted industry panic.

Even back in 1969, shortly after hedge funds began to gain in popularity, terrible results and demands by regulators threatened to ravage the industry.

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