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Hedge Funds Regain Some Swagger

Date: Monday, January 4, 2010
Author: Jenny Strasburg and Gregory Zuckerman

Hedge funds started the year down on their heels and spent much of it trying to regain their footing. The result going into 2010 is a global industry still well off its peak size, but growing once again as investors get back to writing checks and a performance comeback boosts fund assets.

Through November, the most recent data available, hedge funds on average returned 19% in 2009, according to Hedge Fund Research, which tracks performance. That compares with a gain of about 18% for the Dow Jones Industrial Average over the same period, and a 21% rise in the Standard & Poor's 500-stock index.

In 2008, as financial markets tumbled amid a global financial crisis, the average hedge fund world-wide lost 19% on investments. Facing sagging asset values and hesitant to sell into a weak market, hundreds of managers in 2008 and 2009 put up "gates," or restrictions on clients' ability to withdraw money.

The moves sparked an outcry among investors, including influential pension funds and endowments. Investors accused some managers of halting redemptions to keep their funds—and lucrative fee streams—from shrinking. Gates and suspensions of withdrawals remain an issue for investors considering fresh allocations to start-ups or established funds.

Investors opting to put money into funds focused on illiquid, or hard-to-sell, assets, are more accepting of withdrawal restrictions as a "necessary evil" to ensure that outgoing clients and those staying put are treated fairly, but investors don't want to be surprised, says Udi Grofman, a hedge-fund lawyer in New York with Schulte Roth & Zabel LLP. Deep-pocketed investors are driving managers to be clear about whether they are investing in liquid or illiquid assets, and to stick with their strategies so investors know what to expect if they seek to exit.

As they push new cash into managers' hands, investors are tending to favor midsize and bigger funds with track records. "Big beneficiaries from the crisis are multibillion-dollar funds, but not necessarily the biggest ones, that finished 2008 relatively intact," Mr. Grofman says.

As hedge-fund managers generally entered 2009 cautious about the markets, many were holding 50% to 60% of their portfolios in cash, according to data compiled by Mary Ann Bartels, a Merrill Lynch analyst who tracks hedge-fund holdings and performance.

As the economy and markets stabilized, hedge funds jumped back in, buying both stocks and bonds and playing a big part in the resurgence of those markets. Through most of the fall, hedge funds were "fully invested" in the market, Ms. Bartels says.

Wealthy investors and endowments continued to be wary about hedge funds, and many didn't have new cash to invest or an inclination to wager on funds in 2009. But pension funds and foundations started to warm to hedge funds during the summer, setting the industry up for growth in 2010.

Investment gains and inflows helped boost industrywide assets to about $1.5 trillion in the third quarter, after assets had plunged more than $500 billion from their year-end 2007 peak of almost $1.9 trillion, according to Hedge Fund Research.

Just over $1 billion of net investments moved to hedge funds in the third quarter, according to the research firm, the first quarter of positive inflows since the second quarter of 2008.

"We see the early signs of a turnaround" in hedge-fund popularity, says Huw van Steenis, an analyst at Morgan Stanley.

For 2010, some hedge funds say they are concerned about certain areas of the market, such as small banks and financial firms, and are betting on difficult times ahead. Many smaller financial firms are dealing with growing losses from commercial real estate and haven't seen the recovery that larger banks experienced in 2009.

A number of "small, low-priced banks...will ultimately be seized" by the Federal Deposit Insurance Corp., predicts B. Bradley Golding, a managing director at Christofferson, Robb & Co. He helps oversee a fund with less than $100 million in assets that scored gains of 109% in 2008 and was up more than 5% in 2009, through November. The fund benefited in 2008 from betting against stocks through short sales as the market tumbled.

In 2009, with the market sharply up, such bets haven't paid off as handsomely. However, Mr. Golding still sees plenty of opportunities to bet against sectors such as financials. "The majority of these troubled banks have no way to raise capital and thus no way to survive."

Other hedge funds are buying credit-default swaps, effectively a form of insurance against default, on debt issued by nations including Italy, Greece and Japan, anticipating troubles as those nations deal with heavy borrowings.

A growing number of managers, including big names such as John Paulson and David Einhorn, are buying up gold investments, helping fuel a widely watched run-up in the value of the precious metal.

There are other challenges in 2010. An expanding inquiry into suspected insider trading has traders and their bosses on edge—and is causing some investors to question whether certain stock-picking strategies will become less profitable.

Since New York hedge fund Galleon Group was accused in 2009 of illegally trading on inside information, inquiries into the flow of information among companies, Wall Street firms and hedge funds have spread. Galleon and its founder, Raj Rajaratnam, deny wrongdoing.

Lawyers expect legislation that would require funds above a certain asset size to register with the Securities and Exchange Commission. Some lawmakers also are pushing for increased tax rates for hedge-fund managers.

Many funds earned back enough money in 2009 to make up for 2008 losses. "The hiring picture looks strong in early 2010," says John Pierson, who runs New York hedge-fund recruiting firm 10X Partners LLC.

Still, portfolio managers and traders are earning less than they did pre-crisis, Mr. Pierson says, with some fund bosses remarking that just surviving 2008 with a job "is a reward in itself."