Hedge funds add fuel to crisis

Date: Thursday, October 9, 2008
Author: Andrew Tangel, Northjersey.com

Hedge funds, the opaque and often vilified investment vehicles that aggressively maximize profits while flying under the radar, are contributing to the turmoil in the equities markets.

Plunging stock prices have wreaked havoc on hedge funds, which employ sophisticated trading strategies and can often profit from market anomalies or a company's demise. September was the second-worst month for hedge funds since the industry group Hedge Fund Research Inc. began tracking their performance in 1990.

"It's tough out there," said Alan Mark, manager of the hedge fund Raven Asset Management in Maplewood. "We're holding our own, but it's been a difficult environment."

HFR's widely watched index of more than 2,000 hedge funds slid 4.7 percent last month — second only to the decline in August 1998, when the giant hedge fund Long-Term Capital Management LP collapsed. The same gauge shows hedge funds are down 9.4 percent this year, as of Sept. 30.

When hedge funds fare poorly, nervous investors withdraw their funds. Redemption requests, as the withdrawals are called, in turn force hedge funds to sell assets — stocks they hold — to raise cash to pay back investors.

"It could create selling, which would beget further selling," leading to "not a pretty situation," said John Longo, who teaches finance and economics at Rutgers University.

Longo, who also oversees hedge funds for an investment group, estimates that as much as 25 percent of the stock market's recent declines are due to hedge funds selling assets to meet redemption requests.

Andrew Ang, a professor of finance at Columbia Business School, agreed that hedge fund sell-off is partly responsible for driving down markets. Hedge funds have contributed to the markets' "severe volatility," Ang said.

The magnitude of hedge fund sell-off is expected to worsen. Ang said it's possible that 20 percent of the estimated $2 trillion in hedge-fund assets could be sold by the year's end.

What's more, Ang said, is once hedge funds – which are heavily leveraged — sell assets, they have to sell more assets to raise cash to reduce their debt load. "This effect might be much larger depending on what the leverages are of these funds," he said.

Investors receive reports on their hedge funds' performances each quarter typically, and usually must request redemptions three months in advance.

The likely losses will reshape the hedge-fund industry. Though the extent of the impact is a matter of debate, many experts agree that the coming months will see the collapse of many of the more than 10,000 hedge funds.

"I really expect a thinning out of the hedge-fund industry," said Patrick Gaughan, a professor of finance and economics at Fairleigh Dickinson University in Florham Park. He wouldn't be surprised if 25 percent of hedge funds disappeared over the next year or two.

Hedge funds' heavy reliance on credit will be a problem. "The credit crunch may not only affect Main Street — it could affect hedge funds as well," Longo said.

A hedge fund's survival depends on high return for investors, which determines whether fund managers will get paid. Managers rely on cuts of funds' profits, and they often reap 20 percent.

Longo, chairman of the investment committee for the MDE Group, said some of his clients have requested redemptions, though the majority are sticking to a long-term investment plan.

"We're seeing more clients who are more nervous and wanting to go to more conservative positions," said Longo, whose firm manages $1.6 billion.

Mark declined to say whether his fund has received redemption requests but said: "It's a huge issue right now in the community."

"It's understandable that investors out there are concerned about where to put their money," he added. "The difficulty is there's no real answer as a safe place to put it right now."

David Sukoff, a principal with Reade Street Capital, which manages DMS Fixed Income Micro RV Fund in Jersey City, said his firm has seen no redemption requests. The fund, which aims to profit from changes in yields of Treasury bonds, is "actually having a pretty good year," with the firm up more than 20 percent, he said.

Ivan Arteaga, a Saddle Brook investor who manages a hedge fund as well as other portfolios, said last week he hadn't seen any redemption requests. "I have a client base that is very friendly at this point," he said.

Ang, the Columbia professor, said he didn't think hedge funds in the end would have a large effect on the markets. "Yes, they'll contribute to the uncertainty and greater volatility that we see now," he said, but the big problems are housing prices and the credit and banking crises.

"What you're seeing in hedge funds is actually a symptom of much broader, underlying problems."

E-mail: tangel@northjersey.com