Hedge funds do not need punishing - they are suffering enough

Date: Friday, October 17, 2008
Author: Tracy Corrigan, Telegraph.co.uk

Giulio Tremonti, the Italian finance minister, wants to destroy hedge funds – not just a few dodgy ones, but the whole “hellish $2trillion industry”. And when Italy takes over the presidency of the G8 nations in January, he’s going to get on the case.

I can’t help thinking that the G8 will have its hands full, what with the deep and prolonged global recession that is on its way, but he obviously feels pretty strongly about the whole business.

He should save himself the bother. The hedge fund industry is about to implode, with or without his help. Governments were right to step in to support the banking sector because of its vital importance to the broader economy. But there is no need for state intervention either to prop up or crush hedge funds. In fact, the dramatic shrinkage of the industry over the next year or two should provide a useful reminder that it is better, whenever possible, to allow markets to self-correct.

There are, however, some similarities between the predicaments of banks and hedge funds. Favourable market conditions in recent years allowed both to binge on cheap credit, inflating returns – and egos – to unsustainable levels.

Outperformance confirmed many a hedge fund manager’s innate belief in his own trading prowess. However, for all the gloating about the ability to “generate alpha” – the pseudo-scientific term for gains which are not correlated to market movements – the reality was that much of this “alpha” was the result of leverage. Some funds borrowed as much as six or seven times their value, magnifying returns – on the way up.

But the truth will always out in the end. Since the markets turned, investors have started to want their money back.

Outflows have already risen sharply – withdrawals reached $43bn in September, according to TrimTabs Investment Research, and some funds have closed. Others, in an effort to protect themselves, have locked in investors – hardly a recipe for keeping one’s clients happy.

Inevitably, the amount of assets held by hedge funds will contract further, as the industry is hit by a vicious circle of losses as asset prices fall and further withdrawals by investors. At this point, some managers will throw in the towel – particularly those whose funds are structured so that they won’t pay out performance fees again until the fund’s value has surpassed its previous high water mark. It could be a long wait.

There are incidental problems, such as being unable to extract money stuck in the bankrupt Lehman Brothers, and the unwillingness of cash-strapped banks to provide leverage will hit future returns – and future fees.

Bad times for hedge funds will have some knock-on effect on others. Hedge funds will need to have cash available to cope with another flurry of withdrawals at the end of the year, so their continuing asset sales are likely to further depress financial markets. Quite how Mr Tremonti would intervene to destroy the whole hedge fund industry without inflicting unnecessary pain on banks and others is beyond me.

It is unnecessary to “punish” hedge funds because they are already suffering enough. Left to their own devices, there is a reasonably good chance that a smaller group of hedge funds, offering a much better deal to investors, will emerge from the ravages of the financial crisis.

First of all, the shakeout will separate the men from the boys, and frankly there are far too many boys. It is estimated that there are more than 10,000 hedge funds globally. Given the very high fees they charge, they have no raison d’être unless they can produce consistently strong returns, without relying on leverage. I don’t believe that half of them are up to the job.

Secondly, the funds which will do well in the next few years will mostly be those which didn’t use much leverage in the first place. That means they are likely to be better places for pension funds to put our money. Thirdly, while investors whimpered for extra yield, hedge funds were in the driving seat. Now, investors will lay down the law. They will ask for – and I suspect get – lower fees, greater transparency and most of all better access to cash, either on demand, or at regular intervals.

So what should regulators do, if anything? I suspect investors will put their feet down on the issue of transparency, but I cannot be sure because, frankly, they’ve proved a pretty spineless lot in many of their recent dealings – for example with bank chief executives who overstayed their welcome. So some stronger regulatory requirements on that front would be worth having. I’d also let hedge funds resume short-selling of financial stocks — with additional disclosure — since the recent ban has had no tangible benefit and several unforeseen disadvantages. Then I’d sit back and watch the markets do their job, which would be a most refreshing sight. And hedge fund managers, of all people, can hardly complain.