The stampede to escape from hedge funds has longer to run

Date: Monday, March 2, 2009
Author: Nick Hasell, Times Online

If high dividend yields are a sign of distress, then London-listed hedge fund managers are clearly in trouble.

Man Group, the biggest of them all, now offers a prospective yield of 18 per cent; Ashmore Group, the emerging markets fixed income specialist, provides a 10 per cent return. Further down, Charlemagne Capital, the AIM-listed conventional asset manager with hedge fund exposure – which reports full-year figures next week – will have provided a 26 per cent yield for 2008 on its broker’s forecasts.

But such returns are less a reflection of generous payout policies than a measure of how far share prices have fallen over the past year: down 56 per cent in the case of Ashmore and 71 per cent at both Man and BlueBay Asset Management, the distressed debt specialist.

This week’s clutch of results from the sector did little to steady the nerves of investors. Ashmore’s full-year numbers were marred by a £50 million loss on, ironically, a currency hedging position intended to protect its management fees. Bluebay reported an unexpectedly sharp 62 per cent drop in first-half profits and said that its second-half numbers would be no better. Elsewhere, shares in Man were pulled back towards their six-year low amid jitters ahead of next month’s trading update.

The causes of the sector’s malaise are not hard to divine: the wave of redemptions out of leveraged investments and emerging markets in the wake of the collapse of Lehman Brothers; and more recently, the blow to client confidence dealt first by the Madoff affair and, latterly, the alleged $8 billion (£5.6 billion) securities fraud at Stanford Financial Group.

But Morgan Stanley is not convinced that the worst is over. Huw van Steenis, financials analyst at the investment bank, believes that worldwide hedge fund assets under management – which rose nearly fourfold between 2001 and 2007 – could fall below $1 trillion by the end of this year, implying a halving of assets since last year’s high-water mark (see chart below).

He estimates that around one fifth of all hedge fund investments were cashed in the second half of last year – only the second time since 1990 that the sector has suffered a net outflow of funds – but suggests that up to one third of the remaining assets could be redeemed in the current year.

The exit of European investors, especially from once-popular “funds-of-funds”, which back a diverse range of hedge funds, appears to have run its course. Rather, Morgan Stanley is concerned that withdrawals by American investors have yet to peak. Particularly vulnerable are the large US endowment funds that have followed Yale University and spent the past few years diversifying into “alternative” investments, including private equity, commercial property and commodities.

Then there is the direct fallout from Madoff – specifically, the concern that hedge fund managers are falling short in their duties of due diligence.

In the case of Man, Mr van Steenis reckons that its RMF Four Seasons Strategies Fund, which invested $360 million with the alleged US fraudster, could lose a further 60 per cent of its assets, mostly through redemptions. That would imply a slump in Man’s funds to $9 million from $33 billion at last year’s peak. Unlike many rivals, Man has chosen not to lock in restive clients.

Not all is gloom. Recent moves by private equity firms such as Candover, Permira and Texas Pacific to scale back the size of their new funds – and so also the amount that their investors are obliged to put in – should take some of the heat out of hedge funds, given that the sectors share a similar base of institutional investors.

In the longer term, hedge funds should benefit from investment banks’ diminished financial strength. Banks and hedge funds once pursued similar investment strategies, which ultimately diluted their returns. However, with cash-strapped investment banks now having largely wound up their proprietary trading activities, those hedge funds that survive should have the field to themselves.

The countervailing concern is that hedge funds inevitably face an era of intense regulatory scrutiny. In testifying before the Treasury Select Committee this week, Lord Turner of Ecchinswell, chairman of the Financial Services Authority, warned that hedge funds “sufficiently bank-like in their scale” would face similar rules to banks to test their liquidity and capital adequacy. Elsewhere, Charlie McCreevy, the European Internal Market Commissioner, has promised measures for closer direct regulatory oversight of hedge funds by the end of April.

The overall impact is still unclear, but, as Morgan Stanley observes, greater invigilation and increased disclosure imply an additional layer of costs. So where to turn? Pressures on profitability are likely to outweigh the dividend attractions of hedge funds until the dust settles. That suggests a preference for long-only fund managers whose near-term earnings should be driven more by cost savings from consolidation than by a recovery in investor sentiment: Henderson, now the owner of New Star, or Aberdeen Asset Management, newly tied up with Credit Suisse.