Hedge Fund Roach Motels Might Just Be a Blessing

Date: Monday, December 8, 2008
Author: Kevin Hassett, Bloomberg.com

The financial crisis is imposing heavy burdens on the hedge-fund industry, and the strain has become more visible. By the end of last week, about 100 hedge funds imposed restrictions on withdrawals. Many funds have become financial roach motels: Investors can put their money in, but they can’t get it out.

Deregulation has taken a lot of blame for this financial crisis, but an interesting footnote is that the lightly regulated hedge-fund industry has stayed healthy enough to avoid the bailout game.

But are rising redemptions a sign that hedge funds may need a handout, too?

It’s small wonder that some funds have decided to put the brakes on. Morgan Stanley estimates that redemption requests are running at 15 percent to 30 percent of total hedge-fund assets.

One startling sign of how bad things are: even billionaire Paul Tudor Jones, the legendary chairman of Tudor Investment Corp., is limiting redemptions from his $10 billion BVI Global Fund Ltd. Jones has never had a negative year, and this year BVI Global is down a miniscule 5 percent through November. Still, reports indicate that investors have asked to withdraw $1.4 billion from the fund, more than 10 percent of its assets.

If Jones is having a problem, then a run on hedge funds is under way. Three main forces have been driving the flight from even the best funds.

First, the appetite for risk generally has declined worldwide, and investors increasingly are moving their capital to cash or highly liquid investments. How else could we reach the point where the 2-year Treasury pays a lowly interest rate of 0.93 percent?

Pressure on Funds

Second, some hedge funds, such as Kenneth Griffin’s Citadel Investment Group LLC, which is down almost 50 percent this year, have had disastrous returns, and those returns have had a big impact on the returns of “funds of funds” that provide investors with the one-stop ability to invest in numerous funds at once. If investors pull their money out of a “fund-of-funds” then managers have to take money out of the individual funds. And since some of the worst performers have frozen withdrawals, redemptions strike even the better funds.

Third, the hedge-fund industry as a whole has generally outperformed equity markets this year. Many investors have a limit on the proportion of their assets that can be invested in hedge funds, so they paradoxically have to reduce their hedge- fund exposure when equity markets decline.

That’s the bad news. The good news is that the limitations on withdrawals will slow the bleeding, and that should help relieve the pressure on the U.S. Treasury and the Federal Reserve to intervene.

Death Spiral

Without limitations on withdrawals, many hedge funds would fall into a death spiral. Troubled firms would face mass redemptions, which would force them to dispose of their assets. While hedge funds across the industry invest in many different things, it is quite likely that the troubled firms made similar investments, so that the selling would push down prices further, which would fuel even more redemption requests.

Rational investors might easily anticipate this problem, which would encourage them to try to get their money out now. That might be better for investors that get in ahead of the curve, but it is bad news for those in the worst funds.

If you found yourself owning a pile of toxic assets, after bemoaning your lost fortune you would then want to hatch a plan to get as much money out of these assets as you could. The best option would be to gradually wind down your positions over the next few years. That would help you avoid selling into a deteriorating market.

Avoiding a Bailout

The ad hoc limits on redemptions allow firms to pursue such a strategy. They are precisely the kind of medicine the industry needs.

That leads to two policy conclusions. First, lightly regulated firms have nimbly gravitated toward a policy that seems optimal from the point of view of investors and taxpayers. Withdrawal restrictions minimize the chances that the Treasury will have to step in.

Second, it might be that some kind of general “hedge-fund holiday” might be a sensible thing for lawmakers to consider. The best firms may be reluctant to limit redemptions for either strategic or legal reasons. Some cover from lawmakers at this time might not be a bad idea.

After all, it’s not pleasant having a roach motel in your house, but you need one if you have roaches.

To contact the writer of this column: Kevin Hassett at khassett@aei.org