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Clipping hedge funds

31 Dec 08

The financial powerhouses blamed for much of the market crisis are not immune to it and some are taking heavy hits. Hedge funds – until recently estimated to control about $2.5 trillion (£1.7 trillion) of assets, mainly outside regulatory supervision – have been blamed for volatility in stock markets, destroying companies and destabilising the banking system. Now they, too, are suffering the consequences of financial turmoil

by Ian Harper

The Guernsey-based fund of hedge funds, Gottex had to ban withdrawals in an attempt to stem the cash exodus, while the value of its assets slumped 14 per cent in one quarter.

Over the third quarter of 2008, analyst firm Hedge Fund Research of Chicago estimates, investors withdrew a record $31 billion (£21 billion) from hedge funds. It says 350 hedge funds closed in the first half of 2008, 16 per cent more than in 2007, and says 700 could close over the year.

During October the situation escalated, as withdrawals further reduced the value of hedge funds by $100 billion (£68 billion), according to the research house Eurekahedge.

These are the headlines. But how have hedge funds fared as a means of making money when more conventional investments have been in decline? After all, investors might expect to beat the market in exchange for a management fee equalling 20 per cent of profits.

Colin McLean, managing director, SVM Asset Management, says: “The majority of hedge funds have been disappointing in 2008, with many showing greater absolute price falls than clients expected, with a greater period of draw-down, greater month-by-month volatility and more market correlation.

“Some managers may have marketed their returns as having a degree of market correlation, albeit asymmetric, capturing 60-80 per cent of upside but only, say, 40 per cent of downside. Clients may judge that some of these funds have met their objective even with this year’s falls.”

The hedge funds that have done best, McLean says, “seem to have genuine underlying skill, looking for alpha [see definitions panel alongside] that is not dependent on market direction.”

Graeme Currie of Alan Steel Asset Management says: “Hedge funds can make money in a falling market but, like every other investment, you have to be careful and they are not for everybody’s investment portfolio.”

Currie points to Edinburgh-based Cartesian Long Short Equity Fund as a successful operator. Andrew Kelly, an investment partner with Cartesian, says: “The credit crunch has particularly hit businesses reliant on cheap, and easily available credit. Many [hedge funds] used leverage to amplify small investment returns. This was only possible while borrowing was cheap.

“Other funds that have fared badly have been those in illiquid investments. As risk aversion grew, so did the disadvantage of investing in assets tied up for the long term.”

Henry Lee, head of hedge fund advisory, HSBC Private Bank, notes: “Many hedge funds have seen the worst losses ever, yet some have seen exceptional gains. Those equity-oriented managers who were either net-long [see definitions] or value-based investors were very badly affected. Those that were concentrated in the M&A markets were also badly affected. Those that made the right bets on currencies (for example going long on the dollar, or shorting sterling) or those that trade options and were long on volatility, produced strong gains.”

He adds: “The one problem that many hedge funds faced in 2008 was the high volatility that was overlayed with irrationality. Certainly, volatility creates mis-pricing and therefore opportunity, but when it is irrational then poor quality stocks can rise and vice versa for no good reason.

“In the short-term, this can be very damaging for fundamentally oriented investors. The short-financials trade [shorting financial stocks – see “Vocabulary”, previous page] is a case in point. Volatility in those stocks meant that positions could be up 20 per cent in five minutes and down 20 per cent in the next five minutes.”

McLean says: “Some funds were clearly set up to perform well in bull markets, with significant market correlation. In these, few managers had short-selling experience.”

Richard Hodgetts of Collins Stewart Fund Management says: “Before August 2007 we had spent a number of years in a bull market where pretty much any equity bet ended positive. The best performing hedge funds were those that took the greatest risks. A severe lack of appreciation and understanding of risk led to funds and investors losing considerable amounts over the crunch period.”

So what lies ahead? According to Currie: “There will be huge consolidation in the sector and it is estimated up to one-third of all the players will not be there in the future. Regulation may come into the hedge fund industry to stop the shorting we have seen that brought down the financial markets, although I personally do not believe this was the main cause.

“I think the hedge funds are set to bounce back, probably strongly, but there will be fewer players.”

Stuart Ratcliff, CIO of Matrix Money Management’s Fund of Funds business, says: “Potentially, up to 50 per cent of hedge funds could close, with the heaviest incidence on L/S equities [long/ short equities, see vocabulary] and strategies relying on leverage. On the other hand, hedge funds that have survived will emerge much stronger. The market has effectively separated the wheat from the chaff.”

But there may be other changes looming. With their financial structure so far virtually unregulated, hedge funds face calls for greater accountability and transparency, and a larger capital base.

Hector Sants, CEO of the UK’s Financial Services Authority, has said the FSA does not see the need for tighter regulation of hedge funds, and that it does not see them as responsible for the financial crisis. Hedge funds have self-regulated accountability standards issued by the Hedge Fund Standards Board (HFSB).

The European Parliament, however, has adopted a report that demands more openness and tougher regulation of hedge funds. It urged the European Commission to draft tougher rules, including mandatory capital requirements for all financial institutions and codes of conduct for credit rating agencies.

Tougher regulation is also on the cards in the US, particularly once Barack Obama takes up the presidency. Increased regulation is likely to limit hedge funds’ flexibility, narrowing any advantage over conventional mutual funds.

They could become another type of fund competing for much the same business. The wealthy investors and institutions that have looked to hedge funds in the past may then have to seek new ways to buck the market.

IAN HARPER is a freelance business journalist.

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