Shakeout in Hedge Fund Industry Will Be Brutal

If you are tired of watching your incredibly shrinking portfolio, don't feel too bad, you are not alone. It seems this Ursa Major is vicious for all investors, including pension funds, mutual funds and even hedge funds.

Wait a minute, you ask, aren't hedge funds suppose to "hedge" against declining equity markets? The answer is yes, but the reality is that the majority of hedge funds are selling beta as alpha. Their performance goes up and down with the markets.

Nowhere is this more apparent than Long/Short Equity funds where the typical hedge fund manager goes long small cap stocks and short large cap stocks.

The problem is that when a ferocious bear market develops, like the one we are experiencing right now, there simply is nowhere to hide.

Most hedge fund managers are "net long," meaning their portfolios are exposed to the downside when the markets exhibit extreme downside volatility.

The brutal bear market has taken several large hedge funds down. The latest victim, Ospraie Management LLC will close its flagship fund after it plunged 27 percent in August on losses in energy, mining and natural resources equity holdings, in one of the biggest ever closures of a commodities-focused hedge fund:

The closure of the fund, announced by the firm's founder Dwight Anderson in a letter to investors Tuesday, could be more bad news for Lehman Brothers Holdings Inc (nyse: LEH - news - people ), which took a 20 percent stake in the hedge fund manager in 2005.

One expert said the closure of the fund, which at the time of the letter's writing had lost 38.59 percent this year, may also have played a role in bringing down U.S. stocks Tuesday, which fell after initially climbing more than 1 percent. Lehman shares were down more than 3 percent in after-hours trading.

"This is just adding to the fire for commodity-related names," said Peter Holst, managing director at Delta Global Advisors in Southern California. "Even this morning when the market opened, some of the names that Ospraie has positions in were getting hammered."

This high profile hedge fund is not the only one experiencing difficulties. It seems that across the globe, running a hedge fund is losing its allure:

Running a hedge fund has long been considered one of the top jobs in finance, but this summer a growing number of managers have called it quits, unable or unwilling to keep going in what is turning out to be one of the industry's worst years.

Last week, Dan Benton, whose savvy technology bets at Pequot Capital Management and Andor Capital Management catapulted him to star status, told investors he planned to shut down his fund in October. Last month, Ron Insana, a former anchor at the CNBC business network who later promised clients access to some of the world's most famous hedge funds through his extensive contacts, told investors that it was "imprudent" to continue business. And before that, Jeff Dobbs announced plans to shut down Turnberry Capital Management after many of his investors had already asked for their money back.

"There certainly seems to be a bigger number of hedge fund managers going out of business right now than ever before," said Brad Alford, founder of Alpha Capital Management, an advisory firm that invests in hedge funds.

While the three men gave different explanations for getting out of the industry, a common theme seems to be that running a hedge fund may not be worth the headache. Tumbling stock prices and a credit crunch have created volatile markets, and that has translated into losses at many hedge funds.

The average hedge fund, after posting the industry's worst-ever returns in the first quarter, was off 3.54 percent this year through July, according to Hedge Fund Research. While that is less than the average stock mutual fund's roughly 11 percent loss during the period, it is enough to unnerve wealthy investors, who once poured so much money into hedge funds that industry assets doubled in three years.

The article goes on to state:

Hedge fund managers often promised to make money in all markets but several said that shorting stocks, a way to profit in down markets, is becoming more difficult and expensive as ever more investors are trying that strategy, making it tougher and costlier to locate the stocks to short. In a short sale, an investor borrows a stock and sells it, hoping to buy it back later at a lower price, pocketing the difference.

Potential profits have been reduced, with once-sure bets no longer so certain. As a result, the prospect of earning a 20 percent performance fee on profits atop a 2 percent management fee, numbers that lured thousands of traders and portfolio managers into the industry, is in jeopardy. Performance fees are paid for gains, not losses, and this year some individual hedge funds have lost as much as 20 percent, according to investors who have seen the data.

More global hedge funds closed their doors in the first quarter - 170 - than in the period a year earlier, when 138 funds closed, according to Hedge Fund Research. And that number is expected to rise for the second quarter when the firm releases the data next month.

"Hedge fund managers are smart people but they need a trend and there just isn't one right now," Alford of Alpha Capital said. "That sets the stage for a shakeout in the industry where we will soon see the haves and the have-nots."

Adding to the difficulties, raising and keeping capital is becoming harder.

"The fact that investors are quick on the draw to pull capital out makes the management even more difficult in already trying circumstances," said Ken Miller, who tracks hedge funds as head of due diligence at Greenwich Alternative Investment.

It is no wonder, then, that many managers are ready to retire in middle age.

But not all hedge fund managers are ready to retire. The top managers are still very active and their funds are growing and actively recruiting top talent:

While more than 200 hedge funds shut down this year, Balyasny, SAC Capital Advisors LLC and Citadel Investment Group LLC are taking advantage of the industry's worst performance in a decade to go on a hiring spree. Hedge funds, diminished by a scarcity of credit and enfeebled stock markets, fell by an average 4.7 percent as of Aug. 28, according to data compiled by Hedge Fund Research Inc. in Chicago.

Sixty-one percent of the 2,795 funds managing more than $100 million that are in New York-based HedgeFund.net's database are losing money in 2008.

Most managers have what are known as high-water marks that prevent them from collecting performance fees, usually 20 percent of investment profits, until they recoup declines from peak fund values. That leaves a shrinking base of management fees, typically 2 percent of assets, to pay employees.

Firms collecting the most fees have the flexibility to select from the best people who are out of work or searching for a more secure job, recruiters and fund managers said.

The fact remains that the majority of hedge funds, including the ones here in Canada, are struggling to survive.

I quote the following from Lori McCleod's and Andrew Willis' excellent article in the Globe and Mail, Hedge funds face struggle for survival:

Hedge funds saw their ability to borrow curtailed as fears about the health of financial institutions rocked Wall Street. Spooked investors began to take flight, and some funds were forced to sell investment positions to cover redemptions, sinking the value of holdings across the industry.

"The credit crunch starts, and as it progresses it becomes not so much an issue of business and relationships, but an issue of survival," said James McGovern, managing director and CEO at Arrow Hedge Partners Inc., which runs a fund of different hedge funds.

"Some hedge funds were participating in a piece of paper that was incorrectly priced or changed substantially in price, due to what happened with the credit crunch. Others were forced to sell good paper at a discount because the vultures were circling," Mr. McGovern explained. "This, in turn, drives down performance even more, which generates further redemptions, and what you have is a vicious circle."

Large, established Canadian funds - with $1-billion or more in assets - may have a lousy year, but will survive and thrive again, Mr. McGovern predicted. However, smaller domestic hedge funds plagued by weak results will have a harder time keeping and attracting investors.

An attrition rate of up to 10 per cent of domestic hedge funds would not be surprising, Mr. McGovern said. As a rough guide to the size of the sector, Canada's Alternative Investment Management Association has 79 members. Losing 10 per cent of funds would be in step with the yearly global death rate for this "Darwinian" industry, Mr. McGovern added.

The other problem facing many hedge funds in Canada is that they aren't really hedged, or market neutral, Mr. McGovern said. Instead, many funds are chock full of stocks, known in the industry as being long on the market, often looking for operational efficiencies in small- to mid-cap commodities plays.

Indeed, for now investors are trying to see beyond the hedge fund shakeout, focusing their attention in the big banks and large hedge funds:

Oversight and risk-management demands by institutions investing at the big banks will certainly change. And as the big get bigger, performance will undoubtedly suffer, say some observers. A brand name that has deep pockets often offers security, but that comes at a cost, says Charles Gradante, principal of the Hennessee Group, a hedge fund consulting firm in New York.

Big banks will dominate the market and are "more likely to pay out limited partners if there's a blowup, but in most cases very talented people do not want to work for a bureaucracy, unless they are very highly compensated," he says. Still, there may be extra motivation for them to team up with big banks in the short term for survival.

Before the recent market rout, many hedge fund founders, such as those at Citadel Investment Group in Chicago and Blackstone Group (BX) in New York, floated public bonds and equity as a way to monetize their firm's assets. That avenue is closed for now. "The IPO is the preferred way to get your money out and still be a player in the industry," says Gradante. Adds Margaret Gilbert, managing director of Greenwich Alternative Investments, a research and advisory firm to institutional investors: "Big isn't always better, but there's no doubt that the name recognition and the power of their own distribution definitely attracts assets. Everyone knows who Goldman is."

Hedge fund investors say as much. They are bracing for more hedge fund consolidation, and their worries about who will succeed will be the big banks' gain. B. Lane Carrick, chairman and CEO of Sovereign Wealth Management in Memphis manages about $500 million for 175 high-net-worth clients. He runs a fund-of-funds that invests in a couple hundred managers, but he tends to allocate more assets in big shops. "It doesn't mean there won't be a blowup," he says. "But by owning large institutional funds we tend to eliminate the business risk."

But the shakeout in the hedge fund space will get worse. In fact, it will be brutal as this Ursa Major claims more high profile hedge funds in 2008, 2009 and beyond.

Investors better make sure their L/S hedge funds are net short in this environment. Alternatively, they can invest in truly market neutral hedge funds or even better, top-decile low volatility multi-strategy hedge funds (if they can find some that are open and if they can secure capacity).

The point is, if you are going to pay for alpha, make sure you are paying for alpha and not "disguised beta." In this environment, extreme volatility will kill most hedge funds.