Domestic hedge funds face bleak future

Date: Wednesday, October 29, 2008
Author: Andrew Willis, Streetwise Blog, Globe and Mail

Hedge fund investors are opening letters these days that explain why their savings are down 40 or 50 or, gasp, 60 per cent this year, and what portfolio managers intend to do about.

Most of these performance reports contain a frank admission. Fund managers acknowledge that what worked in the past doesn't work any more.

They ask for patience, and continued support. Don't redeem, plead the fund managers. Stick with us, hunker down, and we'll figure out how to make money again when everyone calms down.

There's a degree of honesty to these letters. Any fund manager who claims the worst is over, and that they've figured out how to trade this market is delusional, at best. But investors have every right to wonder whether they should continue to pay 2 per cent maintenance fees, plus 20 per cent for performance, for hedge fund approaches that no longer work.

Most hedge funds have one of two goals: There is a large camp that chases absolute returns, and a smaller camp that swings for the fences in trying to post market-beating performance.

Fund managers in that absolute return world, folks who delivered on their promise of making money in good times and bad during recent months, are candidates for sainthood. Sadly, there's not many of these heroes around.

Funds in that second camp, that tried to turbo-charge performance with leverage and big bets, have lost serious amounts of money. They face a crisis of confidence.

In the domestic market, the downturn has driven home a sobering reality: A great many Canadian hedge funds were leveraged commodity plays. Many of these funds don't have a second act to roll out when the resource story is no longer a crowd pleaser.

The pension fund crowd routinely fires money managers if they break discipline on style - if a value fund manager starts chasing growth plays, that value fund manager gets dumped.

Hedge fund investors should be equally intolerant if a fund that's traditionally focused on long and short positions in energy stocks suddenly dives into, say, distressed debt.

With performance rotten, and unlikely to get better any time soon, expect a number of fund managers to call it a day, as Epic Captial Management did Tuesday.

What started the year as a $300-million, value-focused hedge fund was down 37.9 per cent through the end of September, and Epic founder David Fawcett and his team decided, with redemptions picking up steam, the fairest way to treat all investors was to wind the fund down.

A number of Epic's peers face the same issues, which is why domestic experts agree that a sector that was home to $30-billion of assets not long ago will be managing just $20-billion in a year's time. Or even less.

As funds are closed in weeks and months to come, it's worth recalling that the economics of this industry give hedge fund managers an incentive to shut down beaten up funds, and start over under a new name.

Most fund managers earn their 20-per-cent performance fees only after they beat high water marks, set off returns in previous years. A prolonged slump can leave a fund manager well below that high water mark, and unlikely to earn serious money even if performance picks up. (Epic, by the way, is taking an honourable aproach by maintaining high water marks for existing investors if they continue to back its funds.)

It's interesting to note that the private equity industry wasn't set up this way - fees earned in previous years can typically be clawed back by investors if a fund slumps before it is wound down.

So, how badly will this bear market maul hedge funds? Well, Reuters quoted billionaire U.S. investor George Soros on Tuesday predicting the global financial crisis will reduce the hedge fund industry to as little as one-third of its current size.

"The hedge fund industry is going to move through a shakeout," Mr. Soros said in a speech at the Massachusetts Institute of Technology in Cambridge, Mass. "In my estimation [the industry] will be reduced in size by anywhere between half and two-thirds."