Hard times for hedge funds

Posted by robin in Financial Articles Market Commentary Monday October 20, 2008 5:44 pm

What is the point of a hedge fund?

To deliver absolute returns for investors say their promoters…

To deliver absolute riches for their managers retort the sceptics…

Charging a standard 2%pa and 20% on profits they have been called a remuneration package disguised as an investment.

One at RAB Capital puts it another way. Hedge funds exist to cushion the downside for investors. Why does this matter? Because the shrinks says the pain of losing money is a whole lot bigger than the pleasure of making it. 

Back in 2000-1, when that bear market was kicking in, a well-heeled and fast talking lady from Tremont, a leading hedge fund name, visited the financial advisory firm where I worked. Suitably bamboozled by alphas, betas, leverage, equity market neutral, global macro and all the other hedgespeak she did get across the concept of “shorting”. The idea that you make money when shares are falling in price.

By borrowing shares you don’t own, a successful trade would mean selling them and buying them back later at a lower price, pocketing the difference as profit, and returning the shares to their rightful owner. In that way a hedge fund can make money when share prices are rising (”going long”) or falling (”shorting”).

So, unlike the average unit trust, these funds have the tools available to deliver a profitable return regardless if the direction of the market. Back at the start of the noughties, this was novel to most in the UK and attractive against the backdrop of a falling FTSE.  This two-way betting is how you make your “absolute return” and diminishes the notions of Bull and Bear markets to mere detail. You can still make a profit…in theory. 

And then along comes the mother of all financial storms. Banks get bailed out, US investment banking disappears, losses get socialised and Iceland goes bust. Credit dries up and trendy “asset classes” of every stripe go into freefall.

So how are those absolute returns holding up?

Not so absolute. In the last quarter (July-September) the average fund lost 8.85% says Hedge Fund Research.

Year to date it’’s worse. They’re down 18%.

Better than the broader indices granted (S&P500 down 32%, FTSE 100 down 33%) but not absolute enough to persuade disillusioned investors to stay. Redemptions mean the one time spectacular growth story of the global hedge fund industry went into dramatic reverse.

It shrank by 11% last quarter reports City AM as clients demanded $31bn back and 350 funds closed says the Hedge Fund Review. All told $210bn drained out of the system as June’s $1.93trn cash pile shrank to $1.72bn by September.  

But then, as even their fiercest critics will acknowledge, it was an exceptional quarter. A lethal combination of record volatility, cash calls, redemptions and a selective ban on short-selling has shown us that these geared plays have their limitations. 

Where does the self-enrichment industry go from here? The mood is not sympathetic for these freewheeling investment buccaneers and the spectre of regulation looms large. But the man many regard as the father of hedge funds, Alfred Winslow Jones, had his his bad times too.

Over 34 years, his fund boasted just three down years, against nine for the S&P 500. However, the year 1969-70 was a disaster with more than a third of his fund wiped out against 23% for the S&P 500.

With that in mind, the concept looks to have sufficient history not to be derailed by the setback of a bad quarter, or year. Their bloated ranks may be culled in brutal Darwinian style but, personally, I’d go long on the fittest to prosper anew.