No clear predictions how hedge funds will do in 08

Date: Monday, February 11, 2008
Author: Andrew Leckey, Desert News.com

Even a "go anywhere" investment can go down.

Many of those freewheeling investment partnerships known as hedge funds, which logged an average gain of 10 percent last year, have suffered losses of 5 percent or more in early 2008.

There are more than 10,000 hedge funds, with assets totaling nearly $2 trillion. A large number weren't in existence in 2000, the last time financial markets were badly shaken. So we're breaking new ground, making it difficult to predict how they'll perform in the coming year.

Some smaller hedge funds or those severely pressured by unwise bets will opt to shut down. But hedge funds in general are flexible and represent a host of different strategies, and some actually are designed to benefit from distressed markets.

Most robust have been those hedge funds making global macro-economic bets on currencies, interest rates, commodities or foreign economies. Though they represent a small, higher-risk portion of the overall hedge fund world, they have high visibility and benefit from their contained exposure to volatile stocks and credit.

Former Federal Reserve Chairman Alan Greenspan appears confident, recently signing on as an advisor to the $28 billion Paulson & Co. hedge firm. That company made billions of dollars over the past two years with heavy bets against risky mortgages, a shrewd strategy a number of new hedge funds are now espousing.

Marketed on their supposed maverick ability to avert typical problems faced by more mundane vehicles, hedge funds have as primary customers those well-heeled investors who are willing to pay $1 million or more and accept high fees.

"One mandate of hedge funds is to produce returns that aren't correlated to the overall market," said Daniel Koelsch, director in credit ratings for hedge funds at Standard & Poor's Corp. in Toronto. "That has been put to the test because the performance of hedge funds during a volatile January really wasn't isolated from the overall market."

It isn't so much that hedge funds have become riskier, but rather the market has turned more volatile. Investors must accept that hedge fund performance can be more volatile than so-called "normal" investments, Koelsch believes.

Hedge funds are able to employ speculative strategies that use leverage, options, futures or derivatives, which can magnify negative returns and increase the risk of loss. While not required to register or report to the Securities and Exchange Commission, they are subject to fraud prohibitions and their managers have fiduciary duties.

"There are a lot of cross-currents in the markets today, including the subprime situation and recession," said Thomas Whelan, president and chief executive of the Greenwich Alternative Investments research firm in Greenwich, Conn. "There are certainly a few more things for hedge funds to worry about than a year ago."

Latest hedge fund nervousness, he pointed out, is over the condition of credit default swaps, a huge market used heavily by hedge funds, investment banks and pension funds. The credit default swap market is now being watched closely because it functions as an insurance contract for bonds or bank loans, providing crucial protection against credit risks.

What's in store for hedge funds for the rest of 2008?

"The subprime mortgage theme will drive the returns of traditional and alternative asset classes through mid-2008, if not longer," said Kenneth Heinz, president of Hedge Fund Research Inc. in Chicago.

At that point, there should be many opportunities in discounted securities, Heinz believes, but only for those with the expertise to evaluate the underlying collateral and the capital to participate.

"Hedge funds close up shop all the time because there are cycles for different strategies," said Nadia Van Dalen, hedge fund analyst with Morningstar Inc. in Chicago. "I don't think there will be a general trend of hedge funds shutting down, other than the normal situation of some types proliferating and others going away."

In the meantime, hedge fund returns seem unlikely to equal last year and will have difficulty doing any better than typical mutual funds. But don't expect to see much change in their fee structure, which is often 2 percent of investors' assets plus 20 percent of profits.

The impact of hedge funds on the overall function of financial markets is another factor that will take some time to fully evaluate. Industry trackers believe hedge funds are playing a significant role.

"First of all, I believe hedge funds have stepped in to provide capital and liquidity on a daily basis to the marketplace, helping to make markets in stocks at a time when investment banks have all pulled away from that," Whelan said. "Second, because they tend to trade more, hedge funds are a larger portion of volume today in the equity markets."

Although hedge funds are mostly geared to wealthy investors and institutions, a rising group of low-minimum mutual funds have been introduced that mimic some of their characteristics.

Called "long/short" funds, these are now offered by a number of mutual fund families. For example, they "short" a stock just as a hedge fund would, making a bet stock prices will fall. Thus far in 2008, the 147 long/short equity funds tracked by Lipper Inc. are down virtually the same percentage as the average stock mutual fund, an indication that apparently thinking outside the box doesn't guarantee superior results.

Andrew Leckey answers questions only through the column. Address inquiries to Andrew Leckey, P.O. Box 874702, Tempe, AZ 85287-4702, or by e-mail at andrewinv@aol.com.