Locked away

Date: Friday, December 12, 2008
Author: Economist.com

PICKING the name Fortress for an investment group was no doubt intended to give the impression of solidity. Investors are now discovering another unfortunate connotation: the hedge-fund firm has suspended redemptions and their money is trapped in its vaults.

It is not alone. Tudor Investment, Citadel, D.E. Shaw and Farallon Capital Management are among the other big hedge funds to have restricted the right of investors to withdraw their money.

These firms are among the aristocracy of the industry. Only a year ago, it was widely assumed that hedge funds would increasingly consolidate, with pension funds and endowments choosing to place their money with the market leaders. Some groups were also branching out into other activities, such as private equity and investment banking.

But the trend towards consolidation always faced a potential conflict. It has long been argued that younger funds perform better than those with lots of assets under management. A new study* in the Financial Analysts Journal bears this out.

The problem is that young, small funds do not stay svelte for long. Their success attracts new clients; at some stage, they grow beyond the optimal size for generating high returns. Some managers anticipate this problem and refuse to accept new inflows after a certain point. But the money can be irresistible. After all, the annual fee, say 2%, is predictable; the 20% performance fee, though more lucrative, is not. In fact, the one certainty is that the manager will eventually have a duff year when he earns no performance fee at all.

For a small hedge fund, the annual fee may not be enough to pay the bills. So it makes sense to make the group as big as possible before the inevitable bad year strikes. If the manager closes some funds to new money, he may well decide to start up others. Diversification makes as much sense for the manager as for the investor who spreads his capital between shares and government bonds.

The problem is that a fund manager who diversifies also risks his reputation. Even though all his funds are unlikely to perform badly in any given year (except perhaps a year like this), they will not all outperform either. Worse still, the process of building a big group may draw the original managers into areas like recruitment, marketing and administration, where their skills might not be as polished.

The breakneck growth of the hedge-fund industry from $39 billion of assets at the end of 1990 to $1.9 trillion at the end of last year indicates that the industry overreached itself. The amount of money under management exceeded the number of managers with genuine skill and the range of market anomalies that could be profitably exploited. Too many funds relied on leverage to ride the bull markets.

Clients have been duly disillusioned this year. The average fund lost 17.7% in the 11 months to the end of November, according to Hedge Fund Research, a consultancy. That may be better than equities but is hardly the “absolute return” the industry promised. And the losses that have been revealed may be understated; had investors been able to redeem all their holdings (forcing managers to sell more assets) things might have been a lot worse. Industry enthusiasts claimed hedge-fund returns were less volatile than their conventional, long-only peers. But the price was illiquidity; in other words, all the losses come in a big lump.

Not everyone has suffered, however. Systematic macro funds (which use computer models to bet on global markets) have returned a remarkable 16.8% this year. One fund that has survived and prospered in these difficult times is the aptly named Keynes fund, run by Sushil Wadhwani, which uses a combination of short-, medium- and long-term models to manage risk. The fund was up by 14.1% at the end of November; the leveraged version has returned 43.4%.

The ability of some hedge funds to make money, even in such horrendous circumstances, suggests the industry will survive, albeit in much altered form. It has already undergone several upheavals in its history, including the collapse of Long-Term Capital Management and the fall of the big macro funds in the 1990s.

In fact, the structure of the hedge-fund industry has been far less stable than that of conventional fund management. Perhaps that is because the much-maligned retail investors who back Fidelity or Vanguard are much more patient clients than the pension funds or super-rich who invest in hedge funds.