Hedge funds lose their edge

Date: Monday, October 13, 2008
Author: Eric Reguly, Globe and Mail

ROME — Hedge funds were adept at making money, and lots of it, in any market – up, down, sideways. They would sell short, buy long and use put options for protection. Great gobs of leverage were used to amplify returns.

In spite of notable blowups – Long Term Capital Management and Amaranth come to mind – hedgeland was paradise for many years. Double-, even triple-digit returns were routine. The $2-trillion (U.S.) industry seemed unstoppable.

Until September, that is, when the superhero myth of hedge fund managers was so rudely exposed. Guess what? These guys can't make money all the time. Maybe no one could have, in this meat grinder of a market, but if anyone had a chance of escaping with minor flesh wounds it was supposed to be them. In theory, the funds could even have made fortunes, though the temporary ban on the short-selling of financial stocks crimped the style of some funds.

If schadenfreude is on your list of pleasurable sins, you'll enjoy some of the gruesome hedge fund return numbers for September.

Let's start with Jeffrey Gendell's Tontine Funds, based in – where else? – Greenwich, Conn., the hedgies' “Gold Coast.” Mr. Gendell launched Tontine in 1997 and reaped consistent double-digit returns. The returns in 2003 and 2005 were 100 per cent in each year as his bets on home builders and steel companies, both well on their way to bubble status, proved spectacularly correct.

A Barron's article in 2003 said “he's right so often, he's scary.” He plowed some of the spoils into the Cincinnati Reds baseball team, where he is part-owner.

By the end of September, the fund was down 67 per cent, with almost all of the loss coming in that one month alone. Tontine had $10-billion of investments at the end of June, according to U.S. Securities and Exchange Commission filings. Not any more.

Another surprising loser was Chicago's Citadel Investment Group, run by boy wonder Kenneth Griffin, who is only 40 and was ranked last year by Forbes magazine as the 117th-richest American, with a worth of $3-billion. He got married in the garden of Versailles and paid $60-million for a Cezanne.

Mr. Griffin almost never stumbled, even during the dot-com collapse and the short U.S. recession after the September, 2001, terrorist attacks. From 1998 to 2007, his funds had average annual returns of 20 per cent, or more than three times better than the S&P 500 stock index.

But this market has defeated him. His two main investment funds were down 20 per cent at the end of September as equity trades and arbitrage strategies, like betting on mergers that never happened, blew up.

Unofficial data on about 100 of the leading funds (and circulating among the fund managers) suggests September was the worst month for this particular group of hedgies in years, maybe ever, as no investing strategy worked its magic. All but about 10 of the 100 lost money in September. About 30 of them lost 10 per cent or more, and many 20 per cent or more, with Tontine landing at the bottom of the pile. “Anything we touched, we lost money on,” a Canadian hedgie said.

More comprehensive data from Hedge Fund Research of Chicago said the average hedge fund shed 4.7 per cent in September, taking the loss this year to 9.4 per cent. The October stock-market slaughter, which saw the world's major indexes drop about 20 per cent, is bound to make the October returns even worse.

Any fund that was bullish on energy, commodities and basic materials, or didn't protect themselves from their plunge, is in for a shock. Take Potash Corp. Until a few weeks ago, some analysts had $300 (Canadian) targets on the Canadian producer of potash and nitrogen for crop fertilizers. The shares Sunday traded in the low $90s, a country mile away from the $241 high.

To be sure, the hedgies' losses this year are less than, say, the average mutual fund loss. But that's not the point. These guys were supposed to make fat returns in any kind of bull or bear market and were paid handsomely to do so – generally a 2-per-cent management fee plus 20 per cent of the profits. They were supposed to be smarter than you and me. And for a long time they seemed to be, at least until the big test came.

Some, perhaps many, hedge funds will collapse as they get overwhelmed by investor redemptions; a few have already disappeared, including Ospraie Management's flagship fund. The survivors will become more conservative with leverage, reduce their overheads – goodbye high-priced non-talent – and no doubt cut their outrageous fees. Citadel is already launching a new family of cheapie funds.

Mostly, we hope, they will stop strutting around like roosters and learn a little humility. The hedge fund managers are not gods, as September proved, nor even that smart. Now how about giving back the mansions the investors paid for?