May 11th, 2010 | 
Author: 
Hedge funds had their worst month ever in September (2008). Some of the worst performing segments of the hedge fund industry have been convertible arbitrage, emerging markets, long equity, and distressed assets. There was $43 billion in redemptions in September from hedge funds, many times more than the previous monthly record according to TrimTabs. Some of the biggest names in the business were down 20%+ in September and/or year-to-date. Many high net-worth investors and foundations have invested in hedge funds over the past 5-10 years. I continue to recommend that most individual investors and small foundations be very careful about investing in hedge funds. That is especially true right now.
The stock, bond and commodity markets have been extremely volatile recently. Many hedge funds take directional bets and many of them have been on the wrong side of these bets recently. When volatility is extreme relative to history, many hedge fund risk models do not hold up and the funds end up losing much more money than they thought was possible or probable. Volatility kills any trend-following strategy. Many hedge funds are leveraged (just like the investment banks that have been failing recently). It is not uncommon for fixed income (bond) hedge funds to be leveraged by 20 times their equity. It only takes a small mistake to be multiplied by 20 times to result in sizeable losses for the hedge fund investor. Some hedge funds invest in toxic assets such as mortgage backed securities and credit default swaps that have caused the recent credit crisis in our financial markets.
The recent problems at the investment banks are causing difficulties at hedge funds. The investment banks act as “prime brokers” for the hedge funds. The prime broker is where hedge funds do their trading, shorting, borrowing shares to sell short, and borrowing money for leverage. Right now everyone is deleveraging and pulling back on credit. The investment banks are pulling in risk and capital from everyone including the hedge funds. When a hedge fund deleverages from 20 times to 10 times for example, they must shrink their balance sheets by doing trades that hurt their own performance (selling their longs and buying back their short positions). As clients become aware of this they may want to pull their money out, making the situation worse. The government’s recent temporary ban against short-selling of financial stocks also disrupted a number of hedge funds. It has also gotten more difficult to locate shares available to short and the government is watching and investigating the long-banned practice of “naked shorting” much more carefully right now.
When a hedge fund has a bad year (down 10% or more) it can often spiral downward quickly. Clients pull money out which hurts performance and prospective profitability. Star employees and traders leave as their ability to make money disappears due to a smaller asset base and “high water marks” that require the performance to get back to breakeven before bonuses are paid. As star traders leave and clients hear about it, more clients redeem more dollars which hurts performance again. Hedge funds sell their most liquid assets first when they get redemptions, leaving loyal investors who stay invested holding a higher percentage of illiquid positions. As a hedge fund investor you do not want to be the last one left holding the bag (of shrinking assets, bad performance and illiquid positions) which often creates a race for the exits.
Money is typically pulled from the smaller hedge funds with shorter track records first. High net worth investors and “fund of hedge funds” have the quickest trigger fingers when it comes to selling out of hedge fund positions. Smaller and newer hedge funds have less bargaining leverage in terms of setting up 1-3 year investor “lockup” periods and redemption gates compared to the larger and more established hedge funds.
There will be a big shakout of many of the 10,000 players in the hedge fund business over the next few years. This is especially true of hedge funds with under $1 billion in assets. There are too many players right now that have no real differentiation or edge in the markets and many now have bad performance. Many are not producing good risk-adjusted returns and are not coming close to justifying the typical high fees of 2% of assets and 20% of profits that they charge. I think there will be downward pressure on this high fee structure in the hedge fund industry. Many large hedge funds are already offering reduced fee structures to their big clients in an attempt to get them to commit to keeping the money invested for another 1-2 years.
Hedge funds used to actually “hedge” their risks so that they would actually be significantly less risky than the overall stock market. All of the hedge funds I worked on operated that way. Many still operate this way and provide an excellent product. Other hedge funds think of their business as a giant call option by taking big risks and using leverage and hoping they are right. If they bet correctly the hedge fund manager gets a 20% share of the huge profits and they are set for life. If they bet wrong the clients lose the money and they just close up shop and start a new hedge fund somewhere else or retire. This is the same kind of “heads we win, tails they lose” incentive structure that brought down most of the investment banks in this country over the past few months.
It is very important to do careful due diligence on hedge funds to understand what you are really buying and investing in. Good due diligence is difficult to do because of hedge fund secrecy and the unregulated nature of the business. Hedge funds can be expensive, illiquid, non-transparent, tax-inefficient, and risky. For these reasons and others hedge funds are best used by large sophisticated institutional investors who have the expertise to do a good job of due diligence and monitoring.
Posted in 
Tags: