Caught short

Date: Friday, June 12, 2009

Returns may have improved but hedge funds still face a lot of problems

THE hedge-fund industry is making money again. Figures from Hedge Fund Research (HFR), a consultancy, show that the average fund gained 5.2% in May, the best monthly performance since 2000. Several sectors have earned double-digit returns so far this year.

The rebound comes after a traumatic 2008 for the industry, during which the average fund lost nearly 19% and there was a wave of redemption demands from investors. Assets under management have fallen by around $600 billion from their peak, leaving the industry with just over $1.3 trillion to look after.

Nearly 1,500 funds were liquidated last year, the population of the entire industry back in 1993. Although some new funds have been created, HFR reckons there were just 8,860 funds at the end of March, down from 10,096 in 2007.

This Darwinian process may have helped those managers who survived. A smaller industry means there is less competition for profitable opportunities. Work by Bill Fung and Narayan Naik of the London Business School shows that one of the best periods for hedge-fund outperformance occurred in the aftermath of the collapse of Long-Term Capital Management in 1998. Then, as recently, market prices moved erratically, creating anomalies to exploit.

Taking advantage of those anomalies proved difficult at the height of the credit crunch. Hedge-fund managers needed to hold cash to meet redemptions. In addition, prime brokers (the main providers of finance to the sector) were restricting the amount that managers could borrow. Now JPMorgan, a leading prime broker, is saying that managers are willing and able to borrow again. Not on the scale seen in 2006, admittedly, but enough to take advantage of rising markets.

Even though returns are recovering, the industry is in a much weakened position. Clients are now suspicious of the fees that hedge funds could command in their glory days. A memo from CalPERS, a huge Californian pension fund, said it would “no longer partner with managers whose fee structures result in a clear misalignment of interest between managers and investors.” In practice, that means phasing performance fees over longer periods and demanding that such fees are only generated when the manager exceeds a hurdle rate of return (not zero, as was often the case).

In addition, many investors are now demanding that hedge funds run assets in “managed accounts”, where their money is held separately and the holdings are transparent. In the boom years, hedge-fund managers could afford to refuse such requests, which they tended to regard as too much hassle.

A further advantage of managed accounts, from the investors’ point of view, is that it is easy for them to withdraw their money. Many investors are smarting from their experiences in 2008, when hedge-fund managers abruptly imposed “gates” to restrict withdrawals. Those funds that did resort to gates are still being punished by investors this year. Figures from HFR show that investors withdrew around $104 billion in the first quarter of the year, which was more than 7% of the industry’s total assets.

The bit of the industry that is suffering most is the funds-of-funds sector. It claims, for an additional fee, to be able to put together a portfolio of the best hedge-fund managers. But this claim was rather dented by the exposure of several leading groups to Bernie Madoff. Funds-of-funds are struggling in 2009 as well: their returns are lagging five percentage points behind the average for the industry.

Funds-of-funds are especially vulnerable to an investor squeeze. The investors who have proved most disillusioned with the hedge-fund industry have been high-net-worth individuals, who believed all the talk about “absolute returns” and were dismayed by last year’s double-digit losses. That means the industry will become more focused on institutional investors like pension funds and endowments. But these investors can develop their own expertise in picking the best funds or may opt for model-based “clones” that aim to produce hedge-fund-like returns at lower cost.

To add to the industry’s problems, it faces renewed interest from regulators. Managers are particularly exercised by a draft European directive which will impose limits on leverage and greater requirements for transparency, which could limit returns. Among other things, the new rules also require prime brokers to be resident in the same jurisdiction as their clients, a mindless piece of bureaucracy. From being masters of the universe two years ago, hedge-fund managers now fear becoming servants of Brussels.