Trimming the Hedges

In July, 2007, I wrote an article about hedge funds. Way back then, when everyone and his brother was just dying to work for, start or invest in a hedge fund, I noted that
“Only the cream of the crop end up in the big leagues, while the rest of the heap slug it out in the minor leagues.” Well over a year later, it appears that there are problems in both the big leagues and the minors. Hedge funds are on track to have one of their worst years ever.

Louise Story noted in the New York Times (10/23/08) that “The gilded age of hedge funds is losing its luster.” Storied names in the industry have seen portfolios halved this year and smaller ones have been forced to close as once-aggressive investors run to the sidelines. I have heard a familiar story from many sophisticated investors: “My love affair with hedge funds is over!” No longer can hot-shot managers promise 1% per month with low risk, because it is simply impossible to deliver. One family friend noted “I could save the 2+20 (referring to the average hedge fund fee structure which amounts to 2% annual fee plus 20% of the profits) and lose the money myself or with a buy side manager for only 1%!” This guy had invested in six hedge funds as of last quarter, but now has just one.

Of course this type of thinking creates a vicious cycle: the massive number of investor redemptions puts more pressure on managers to unwind trades, forcing sales across every asset class, which in turn causes everything to drop in value and thus perpetuating more redemptions. And when people decide enough is enough, they throw the towel in on everything, even the stuff that is doing well.

As a case in point, my pal started a currency hedge fund at the beginning of the year and is actually in the plus column through yesterday’s close. Yet he is fearful that his major investor will not be interested in assuming any more risk when the redemption window opens early next year. While they have no complaint about performance, it is simply a decision to reduce risk. Of course my friend knew that this was a risk that existed when he started out, so there are no sour grapes, but it does beg the question, does the world really need over 10,000 hedge funds? Probably not, but it will be interesting to see which ones survive and how the pension and endowment world will view the world of “alternative investments” when they no longer are making easy money.

Like most booms and busts, there will be talk of the entire industry disappearing, but those predictions are usually overblown. Even the dot-com meltdown resulted in a few strong and profitable companies that thrive to this day. The more sobering question that smaller managers will ask is where can they go? With layoffs escalating on Wall Street, many of these guys may be left to make money by simply trading their own investment accounts -- at least until the process of hedge trimming is complete.