'Hedge fund collapse is on the way'

Date: Monday, October 8, 2007
Author: Steve Johnson, FT.com

Investors will withdraw $500bn (245bn, 355bn) a quarter of the asset base from hedge funds in the next year, leading to the collapse of a "large number" of hedge funds.

So spredicts Giles Conway-Gordon, managing partner of Cogo Wolf, a San Francisco-based fund of hedge funds, who believes investors are increasingly dissatisfied with industry performance, and that computer-driven quantitative hedge funds now simply run too much money to make healthy returns.

"I don't think it [the hedge fund industry] can support $2,000bn of assets. I think we are going to see large numbers of hedge funds go out of business, and rightly so," he says. "Hedge funds are supposed to avoid losses when things are bad, but there are very few that can break even then. I think a lot of them are not earning their keep.

"There's a hell of a wave of money, say $500bn, coming out of hedge funds over the next year. There is going to be more of a focus on demonstrable results and track records that do not rely on 10-12 times leverage.

"I think we are going to see a very sharp Darwinian process in the next six months. Things have been too easy for too long and I think cold winds are about to blow."

Mr Conway-Gordon's comments come as much of the hedge fund industry has struggled to cope with the market turbulence. Two hedge funds run by Bear Stearns and one managed by Australia's Basis Capital have filed for bankruptcy, while others run by Goldman Sachs and Sowood Capital have encountered severe problems.

The HFRI Fund Weighted Composite Index fell 1.3 per cent in August, even as the S&P 500 index rose 1.5 per cent, although hedge funds made money in June and July when the S&P fell.

Mr Conway-Gordon, a 20-year industry veteran and former director at GAM, believes "black box" quant hedge funds in particular face a moment of truth. "We don't believe in this quant stuff, it's like using only the rear-view mirror and blacking out the windscreen when driving a car."

While the market backdrop may have been supportive to quant funds in the past, he fears the current environment will find many managers out. "It worked when not too many people were doing it, but it's now starting to fall apart. As soon as the road bends only slightly you are off the road. If you have got 10 times leverage in your engine you will come a cropper."

In contrast, Mr Conway-Gordon uses no leverage, does not invest in hedge funds that are more than twice leveraged themselves and favours fundamentally driven hedge funds.

His $65m Cogo Wolf Global Strategy Fund has responded by producing a five-year annualised return of 21.7 per cent in the period to July 31, comfortably ahead of the MSCI World equity index and more than double the return of the HFRI Fund of Funds Composite Index, although a wobble in August will have reduced this to a degree.

This outperformance has largely been driven by Mr Conway-Gordon's faith in two interlocking themes; the strength of both emerging markets and commodities. He argues that the rapid changes underway across a swathe of emerging markets, lifting large numbers of people out of grinding poverty, are the sort of global shift that happens only once every 75-100 years.

He is playing this theme through holdings in a dozen long/short equity funds focused on India, China, Russia, Africa and Latin America. In spite of his optimism towards the asset class, he still argues that gaining exposure via hedge, rather than long-only funds, is beneficial.

"There is a long bias to emerging market funds as you don't tend to get the shorting mechanisms there. But we prefer to be in the hands of people who will have the avoidance mechanisms, rather than simply being long-only."

Natural resources, one of the factors that have helped power the rise of many emerging market economies, are Mr Conway-Gordon's other pet theme. In particular, he is enthusiastic about gold in spite of the fact that prices have already surged to a near 28-year high in nominal terms, with the most recent leg-up aided by the crumbling US dollar.

"The dollar is going to continue weakening. It's the end, probably, of the dollar's dominance in the international arena."

If Asian and Middle Eastern central banks come to the same conclusion and start to switch a slice of their vast foreign reserves out of the greenback, he believes gold will be a prime beneficiary.

"After the [second world] war gold was the balance of foreign exchange reserves, now it is tiny," he says.

Figures from the World Gold Council indicate that 76.1 per cent of the foreign reserves of the US are currently held in the form of gold, 63.2 per cent of those of Germany and 56.9 per cent of those of France.

Yet the proportion of gold held in Asia, where foreign reserves are growing fastest, remains negligible. Just 0.1 per cent of South Korea's reserves are held as gold, 1.1 per cent of China's and 2.4 per cent of Russia's.

"If we are entering a period where there are question marks about developed economies, and the dollar in particular, I would be increasing gold to 5 per cent in my reserves."