Hedge-Fund Destruction Is the Route to Salvation: David Reilly

Date: Friday, March 6, 2009
Author: Bloomberg.com, Commentary by David Reilly

Like plenty of financial players, hedge funds are taking a beating.

Many once-high-flying managers have been swamped by losses. Others have abandoned the business after discovering it wasn’t such an easy path to riches. Even some of the biggest firms -- Citadel Investment Group LLC, D.E. Shaw Group and Tudor Investment Corp., among others -- have had to block investors from withdrawing money.

This is great news for, well, hedge funds and their investors.

The retrenchment might force hedge funds, lightly regulated investment pools, to rediscover what they once were -- small, guerrilla investors focused on returns, not artery-clogging management fees.

Getting back to that primal state will involve pain. The culling of the hedge-fund herd probably will worsen as investors flee in the face of market declines and the Bernard Madoff scandal.

Assets managed by hedge funds might fall to half their 2008 peak of about $1.9 trillion, Morgan Stanley analyst Huw van Steenis estimated in a report earlier this week.

That outflow would come on the back of a 19 percent decline in investment returns for hedge funds in 2008, as measured by Hedge Fund Research Inc.’s weighted composite index. While that beat the 38 percent decline in the Standard & Poor’s 500 Index, it is cold comfort to investors who expect hedge funds at least to preserve capital, if not live up to their billing of being able to profit when others are hitting the skids.

Past Due

A winnowing of the hedge-fund industry will likely leave the survivors either managing far less money or focusing more on a handful of investment strategies.

This is a long-overdue correction. Once upon a time, hedge funds were a cottage industry. Aside from a few big operators like George Soros, most managed less than $500 million.

They ran one, maybe two funds. They were nimble. They were hunters.

The bursting of the tech bubble changed the game. Hedge funds were among the few making money in the bust. Pension funds, charities and university endowments took note and sent dollars their way.

That awakened banks and investment houses to the idea that hedge funds could be big business. The plan was to marry fund managers with the sales and distribution force, as well as infrastructure, of an established institution.

Going Mainstream

London-based fund-management firm Man Group Plc in 2002 set the stage for this shift with its $830 million purchase of Swiss fund-of-hedge-funds manager RMF Investment Group. The seminal moment came in September 2004 with JPMorgan Chase & Co.’s acquisition of a majority stake in Highbridge Capital Management, a hedge-fund outfit overseeing about $7 billion.

Hedge funds had gone mainstream. Assets under management soared to almost $2 trillion last year, from less than $500 billion before the start of the decade.

With so much money to be had, too many funds became asset gatherers akin to mutual funds. Managers previously glued to trading screens spent their time on marketing trips.

Who could blame them? Hedge funds’ fee structure -- a 2 percent management fee coupled with 20 percent of the profits -- meant a fund managing $5 billion could pull in $100 million just for turning on the lights.

As many funds surpassed the $10 billion mark, the law of large numbers kicked in. Returns faded.

Short Squeeze

Hedge funds’ growing heft, along with easy access to borrowed money, or leverage, also meant it took more to move the performance needle. More limited investment options, in turn, led to funds huddling in similar trades.

That saddled them with dangerously similar risks. Last fall, numerous hedge funds piled into a trade that bet shares in Volkswagen AG would fall while stock in Porsche AG would rise.

The trade crashed when Porsche, which held a large stake in VW, forced up the value of VW’s stock in the options market. Those shares jumped briefly to more than 1,000 euros from 200. Hedge funds were left licking devastating wounds, with estimated losses of as much as 10 billion euros.

Small single-fund shops also became passé in the bigger-is- better boom. Managers expanded their offerings; many lost their edge along the way.

Those days may be past. Today’s carnage will force hedge funds to shrink. That will push managers to again focus on performance.

Now-jaded investors might also prove reluctant to throw cash at marquee names, realizing that outsized returns are more likely to come from small, upstart managers than their older peers dining out on past glories.

There will always be big hedge funds, of course, especially those engaged in fixed-income, distressed-asset or computer- driven investment strategies. A big chunk of the industry, though, might be made up once again of firms where a couple of managers running a few hundred-million dollars chase their own novel ideas.

If that’s the case, hedge funds may just go back to being hedge funds. Investors would be better off for it.

(David Reilly is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: David Reilly at dreilly14@bloomberg.net