The Year Hedge Funds Got Hit

Date: Monday, January 5, 2009
Author: Ellen Nakashima, Washington Post

Hedge funds, the highflying darlings of the investment industry, have fallen to earth. These funds meant for sophisticated, rich investors just endured their worst year ever.

The industry was down 18.5 percent as of November after an unprecedented six-month streak of losses. The amount of money the hedge funds had to invest, which peaked at almost $2 trillion last June, shrank by almost one-fifth by October, according to Chicago-based Hedge Fund Research. Some fund managers say the industry's capital could shrink by as much as 75 percent.

Tens of billions of dollars are being pulled out of these secretive funds by nervous investors who seek to put their money in safer alternatives or need cash to meet other investment obligations.

The wild swings in the stock market last year were due in part to hedge funds selling assets to meet redemption requests and to reduce leverage levels, analysts said.

The past 12 months have been "an indescribably horrific year and everything's been down," said Robert A. Dennis, investment director of Massachusetts Public Employee Retirement Administration Commission, which oversees municipal pension funds, a number of which have invested in hedge funds. "This year is to be written off as a horror movie to be seen once and never again."

Once predators on the margins of the market, hedge funds have grown into integral participants. Now they are under enormous stress. Congressional hearings have highlighted their potential to put the global financial system at risk through excessive use of debt to finance investments and through extensive links with banks and other large financial institutions. More and more pension funds and college endowments have been investing in hedge funds, and pressure is mounting for regulation of the funds.

"We've been living on borrowed time in that the industry has grown far more rapidly than we've been able to support with the existing legal, regulatory and investment infrastructure," said Andrew W. Lo, director of the Massachusetts Institute of Technology's Laboratory for Financial Engineering.

Though hedge funds are suffering, they have lost only about half as much value as stocks, which declined 38 percent last year, as measured by the Standard & Poor's 500-stock index.

Most institutional investors seek a diverse portfolio of multiple hedge funds, said David Shukis, director of hedge fund research and consulting for Cambridge Associates, which advises college endowments and other institutional investors. "That combined with very good performance relative to equities going into this has led most investors to think that it's still an attractive investment to have in their portfolio."

But that is still billions of dollars in losses for investors, which include typically staid public pension funds. In Pennsylvania, the state pension fund declined 14.4 percent in the first nine months of last year, to $29.2 billion. Just under one-fifth of its assets were in sophisticated investment strategies that included hedge funds. Those strategies were down, on average, 31.5 percent in the same period.

Ordinarily, market turmoil and economic volatility are good conditions for hedge-fund masters like Paul Tudor Jones, who foresaw and profited from the 1987 market crash. But now even Jones, hailed as a "financial alchemist" and "market wizard," is finding he is all too human.

His $10 billion flagship fund, Tudor BVI, is on track to have its first down year in 22. So many investors want to yank their money out that the fund has for the first time temporarily barred them from doing so. In a Nov. 28 letter, Jones asked them to "pause" while he deeply rethinks his strategy.

The hedge-fund industry's capital base hit an all-time high of $1.93 trillion in June, according to estimates by Hedge Fund Research, which tracks self-reported data from 7,800 funds. By October, that base had declined to $1.56 trillion, with investors withdrawing $70 billion and performance losses accounting for $300 billion.

Industry participants, including some fund managers, said that hedge funds have significantly reduced the amount of debt they have taken on to finance investments, with many now at more modest leverage levels of less than $2 of borrowed money for every $1 put up by investors.

"Hedge funds were . . . an integral part of the bubble," said George Soros, one of the world's wealthiest and most prominent hedge-fund managers, in testimony to Congress last fall. "But the bubble has now burst, and hedge funds will be decimated."

Some say this is a winnowing out of the weak, the reckless or the unlucky. Hedge funds experienced the largest performance spread in their history last year, with the bottom 10 percent losing more than 58 percent and the top 10 percent soaring more than 40 percent, according to Hedge Fund Research.

The industry was founded by legendary traders who set up firms and charged what were then thought to be outrageous fees: 2 percent of assets and 20 percent of investment gains.

And the money rolled in. Because they were mostly unregulated, they did not have to restrict themselves to one type of investment or strategy. So they bet on currencies, commodities and stocks. They could buy long and sell short. They traded in tungsten and titanium, Icelandic ice and weather derivatives.

From a few hundred funds in the early 1990s, the industry -- which caters to wealthy and institutional investors -- ballooned in the past decade, swelling to more than 10,000 funds last June. As TPG-Axon Capital Management's manager Dinakar Singh put it, "hedge funds have grown from being opportunistic investors circling the market for opportunities to actually being a core part of the market itself," moving from "sniper to infantry." The managers, it seemed, minted money.

Hedge funds did not cause the current crisis, analysts said, but they helped amplify it by buying many of the risky mortgage-backed securities that grew the financial-markets bubble.

When the bubble burst, these funds were among the first to experience losses. In late 2006 and early 2007, dozens of large funds began losing money or folding as mortgage defaults rose. In summer 2007, two Bear Stearns hedge funds, which had invested heavily in subprime mortgages, collapsed. That summer, Sowood Capital Management, a hedge fund in Boston, having lost half its capital following losses on bond market investments, was sold to Citadel Investment Group, which runs some of the world's largest hedge funds. Citadel's two largest hedge funds, with about $10 billion in capital, lost 50 percent of their value in 2008.

In recent years, much of the money raised by hedge funds has come from pension and endowment funds, which were seeking high returns with what seemed like low risk.

"The problem with most pension-fund relationships with hedge funds is that they're opaque, and in order to know what to do with the market index and the options, you need to know what is going on in the hedge fund," said H. Sean Mathis, an investment adviser. "What went wrong was you didn't know what the hedge fund was doing.''

In Massachusetts, the $39 billion state pension fund was down 30 percent last year through November; its investments in various hedge-fund strategies declined 18 percent on average in that period. "You can't be an investor if you can't afford losing money at some point," said Michael Travaglini, executive director of the Pension Reserves Investment Management Board, which oversees the state pension fund.

Indeed, in October, the management board increased the portion of its investment in hedge funds by one percentage point, to 11 percent of the pension fund. And the municipal pension oversight board likewise decided to allow cities and towns with funds as small as $150 million to follow suit.

Nonetheless, many of the investors lining up to get their money back are pension funds and endowments. Pennsylvania has redeemed $1 billion, though Massachusetts has not sought to withdraw money.

Last month, five hedge-fund managers who each made more than $1 billion a year were called before Congress to discuss the industry's role in the crisis and the case for regulation. Four of the five said they thought that hedge funds could pose a systemic risk to the economy. "Any institution that has a pool of capital at its availability and uses reckless leverage indeed poses a potential systemic risk to the marketplace," said Philip A. Falcone, manager of Harbinger Capital Partners.

When pressed, the hedge-fund gurus agreed that they could probably live with some form of disclosure to a federal banking regulator, as long as the data are not shared with the public.

Understandably, some fund managers see opportunity in the economic turmoil. "Markets are a train wreck," Singh told investors, "and there is substantial opportunity to profit handsomely."

Staff researcher Robert Thomason contributed to this report.