Hedge funds seen keeping tight hold of borrowing

Date: Tuesday, March 25, 2008
Author: Kevin Plumberg, Reuters.com

NEW YORK, March 24 (Reuters) - Hedge funds paused on Monday from last week's aggressive moves to pare debt and add cash to their balance sheets, but few are expected to return to a reliance on strategies involving heavy borrowing because of the permanent damage of the credit crisis.

Hedge fund advisers and fund managers said they believed the crisis was far from over, with the roughly $140 billion of write-downs at banks so far around the world only the beginning, keeping lending conditions tight and fears high about the viability of creditors.

As a result, last week many funds took profits on positions in which they were ahead and used the cash to plug holes in their portfolios, causing the biggest crash in the commodities market in 50 years.

A lot of these positions had been leveraged to varying degrees, using borrowed money to enhance returns. When the price of an underlying asset moves sharply in an adverse direction, causing lenders to call in their debts, some funds can go bust, such as Amsterdam-listed Carlyle Capital (CARC.AS: Quote, Profile, Research), which defaulted on $16.6 billion of debt earlier this month.

Equity and commodity prices as well as foreign currencies could all tumble if hedge funds have to keep liquidating their best trades to generate cash on their balance sheets.

"People have just got burned on leverage," said John Mauldin, president of Millennium Wave Investments, a hedge fund investment adviser in Arlington, Texas.

"When you kill 60 percent of your customers with subprime exposure and then you wound the other 40 percent, they are not going to want to buy this stuff anymore."

He believes that a "significant" number of hedge funds will go out of business in the next three to five years because of the difficulty of generating high returns with low leverage.

In their place, Mauldin said he expects more funds of funds, with highly transparent portfolios along with higher risk premiums, to produce somewhat modest returns of 8 percent to 10 percent with lower fees. That would be a far cry from the returns in the high-teens reaped in the heyday of the credit bubble.

THE TIPPING POINT

Mauldin added that more funds may focus on finding assets for heavily discounted prices and then selling them at a premium, rather than using leverage to augment bets against an asset.

In what could be a preview of what is to come for the hedge fund industry, money management firm BlackRock Inc (BLK.N: Quote, Profile, Research) and hedge fund Highfields Capital Management on Monday said they were backing a new firm that will buy up distressed mortgages, betting that investors are ready to snap up bargains in the beaten down sector.

David Greenwald, chief operating officer at TG Capital in Newport Beach, California, a hedge fund that invests in currencies only, also thinks the worst may not be over for some funds.

"You are seeing some very aggressive moves by hedge funds having trouble with liquidity to sell their winning trades. I could see more hedge funds collapsing after the banks," said Greenwald, who helps to oversee $200 million in assets.

The $1.79 trillion hedge fund industry is mostly struggling to keep clients' money amid heightened market volatility and tightening credit markets.

Total net flows of fresh money into hedge funds slowed by two thirds to $13 billion in the final three months of 2007 compared with the third quarter, according to data from Lipper HedgeWorld.

Two of the three strategies that worked best at hedge funds in the third quarter no longer did well in the fourth quarter, the data showed.

Liquidation of winning trades was on fully display last week when gold and oil prices dropped more than 7 percent. Net selling of Australian dollars by hedge funds last week was the most since July 2006, according to UBS.

With its relatively high interest rate, the Australian dollar had been a favorite of investors putting on carry trades, in which a low-yielding currency is borrowed to finance purchases in another higher-yielding currency.

That trade has been severely curtailed.

"People don't want to face off with the prime brokers and they want to get cash on to their balance sheets," said Geoffrey Yu, a currency strategist with UBS in Zurich.

"We have reached a tipping point at which funds no longer could afford to be so highly leveraged." (Additional reporting by Gertrude Chavez-Dreyfuss; editing by Leslie Adler)