The Hedge Fund Apocalypse

Date: Monday, October 20, 2008
Author: Liz Moyer, Forbes.com

Billionaire investor Warren Buffett wants his fellow Americans to buy stocks, but the Greenwich, Conn., set couldn't take his advice if they wanted to. As investors scream for their money back, hedge fund managers are as paralyzed as the rest of Wall Street.

Hedge fund assets shrank by $210 billion in the third quarter, hit by volatility, higher borrowing costs and $31 billion in redemptions after a wave of investor panic.

The carnage is the worst in the industry's history, surpassing the jolts in 1998, 2002 and 2005, according to Chicago's Hedge Fund Research, which has tracked fund assets and performance since 1990. Funds are scrambling to meet the withdrawal requests, helping to push the major stock averages down in the last few days, and many won't be able to continue in business.

So far this year, 350 funds have closed shop, but that doesn't count the third quarter, when most of the bloodletting has taken place. Ken Heinz, the president of Hedge Fund Research, says he wouldn't be surprised to see 1100 funds liquidate this year.

That would be three times greater than in 1998, when $4 billion Long-Term Capital Management had to be rescued. "We've never seen it happen in this magnitude," Heinz said.

The research firm's hedge fund composite index dropped 8.8% in the third quarter and is down more than 10% for the year. The quarter's performance matched the decline in the Standard & Poor's 500. But year-to-date, the decline in hedge funds is far less severe than the rout in the index, which is down 35% since January.

That should be enough to encourage money into funds instead of out of them--indeed many previously closed funds have reopened to new investment. But investor confidence has shriveled in the face of a highly correlated market with no safe havens.

Investors suffering sharp declines in their holdings and margin calls are redeeming investments where they can. And hedge funds that were not in a bad position going into September are preying on the funds they are trying to liquidate.

The turmoil hasn't spared the industry's brightest stars. Ken Griffen's Citadel Investment Group reported 26% to 30% declines in two of its funds for the quarter and had to go out on the defensive after a spate of rumors about performance for the group overall sent the spreads on credit default swaps in Citadel soaring.

"We have never backed down when faced with a challenge, and this time will be no exception," Griffen said in a letter to clients in which he expressed regret for not anticipating the severity of the credit crisis.

Highland Capital Management in Dallas is closing two of its funds, with combined $1.5 billion under management, after losses. Perry Capital cut 20 to 30 jobs and is turning its focus away from stocks to credit-related trading strategies, where it sees more opportunities.

Other fund managers have sent apologetic letters to investors. "We clearly underestimated several things, most importantly the tsunami of redemptions that are being delivered to hedge funds as investors line up to get our of these funds as well as record outflows from equity mutual funds," said Jeffrey Gendell, general partner of Tontine Associates, in an Oct. 1 letter.

Total industry capital at quarter end was $1.72 trillion, down from $1.93 trillion in June.

Withdrawals entirely offset the capital inflows into hedge funds during the first half of 2008, bringing year-to-date net capital flows to a decline of $2.5 billion. Last year, inflows into hedge funds reached a record $194 billion.

Funds of funds did poorly as well, falling 9.7% for the third quarter and 11.8% for the year, and investors withdrew $13.3 billion in the last three months, according to Hedge Fund Research.

This year could be the first negative year for the industry since 2002, when the average hedge fund lost 1.45%. September was the cruelest month, with average declines of 5.5%, the second worst single month for the industry, according to Hedge Fund Research, behind the 8.7% average loss in August 1998.

Since peaking last October, hedge funds have lost 11.5%--mostly because of performance--an amount that surpasses the losses in 1998, which was about the time of the collapse of Long-Term Capital Management.

Andrew Lahde closed his one-year-old fund Lahde Capital last month after 866% returns because he said his bank counterparties had gotten too risky to trade with. On Friday, his Dear John letter to the industry was widely circulated on the Internet. In it, he called business school graduates idiots glued to their blackberries not worthy of the educations and responsibilities they'd been given.

"Give up on leaving your mark," he said in the send off. "Throw the Blackberry away and enjoy life."