A Cruel Summer for Hedge Funds?

Wall Street Journal senior writer Gregory Zuckerman was interviewed on Yahoo Tech Ticker saying it's a cruel summer and hedge funds are struggling too:

2010 has been filled with uncertainty and volatility; after some peaks and valleys, stocks are just about where they started in January. Even after a 10% gain in the last month, the Dow is only up about 2% year to date.

That’s making it difficult for individuals and the pros to make money. “It’s a tough summer,” says Wall Street Journal senior writer Gregory Zuckerman. The lack of direction on the economy is wrecking havoc on hedge fund strategies, he tells Henry in this clip.

Through the first half of the year, hedge funds are only up about 1%. “They can’t figure out right now a really good trade,” says the author of The Greatest Trade Ever. Hedge fund manager Philip Falcone is a prime example. After a 46% gain last year and a 116% return in 2007, his Harbinger Funds are suffering as of late. “As of July 15, Falcone's Harbinger Capital Partners Offshore Fund I was down 10.7 percent, ranking the New York-based fund manager one of the industry's 20 worst performers, according to HSBC,” Reuters reports.

It’s times like these that have many investors waiting it out on the sidelines.

Ironically, one of the most bullish managers around is John Paulson, the man made famous for making billions by betting on the housing collapse. He owns large stakes in banks such as Bank of America and Citigroup, and has told investors he expects the real estate market to bounce back 3-5% in 2010 and 8-12% in 2011. (Update: Recent market volatility has prompted Paulson to rein in his horns a bit. The $3 billion Paulson & Co. Recovery fund, launched in 2008, has decreased its net exposure from 140% to 107% in recent weeks, The FT reports, citing a letter from Paulson to clients.)

Meanwhile, as mentioned in a previous segment, other hedge fund giants are betting on deflation. David Tepper, who raked in $4 billion in 2009 by getting bullish at the bottom of the market, is not as sanguine about stocks. He has a large position in high-yield debt.

So what's going on with hedge funds? Tyler Durden of Zero Hedge posted an interesting comment on the impact of the liquidity crisis on the hedge fund industry, citing a report from Citi Perspectives (click here to view report). Tyler ended on this note:

Yet this pearl takes the cake, as it basically confirms that for the longest time the entire industry was a Ponzi scheme:

“There were accepted practices going on in the industry up until 2008 that in retrospect look like a problem. Funds were using the liquidity of incoming investors to pay out the established investors without testing the investments themselves. It was hard to see this until everyone hit the exit at once and everyone starting asking for their money back at the same time.”

– Fund of Fund & Seeder

Clearly there was a 'Ponziesque mania' that surrounded hedge funds and other alternative investments, and global pension funds share a lot of the responsibility as they bought into the mania at the top of the market.

But there is something else going on with hedge funds. Post-crisis, a lot of them have not adapted, and are not able to deal with the structural changes impacting their industry. The top hedge funds have adapted, but most are struggling in the new environment where investors demand a liquidity premium and a lot more transparency on the risks being taken.

It's quite amazing that the 2 & 20 model still persists, but with pensions suffering record shortfalls, few are muscling hedge funds on fees. Not that I think they should. What pensions need is to start leveraging off all their external managers. They need to view external managers as a valuable source of ideas, and build on these ideas through internal strategies to add value to overall returns. (Easier said then done. To do this properly, you need excellent relationships and internal expertise to properly implement ideas).

And in terms of investments, the easy money was made in 2009, but now that the big beta boost is over, the wheat will get separated from the chaff. I happen to disagree with both John Paulson and David Tepper. The rally in equities will go on as long as the Fed is allowing banks to borrow cheaply and invest in risk assets all around the world.

But there are important structural forces weighing down long-term economic growth. From high unemployment to demographics, it's hard to see a significant pickup in inflation expectations anytime soon. Inflationary forces are still fighting deflationary forces, and with no clear winner, markets could be range-bound for a long period.

There is a caveat to all this. Watch what is going on in emerging markets because if they start exporting inflation, it could be a structural shift that leads to global stagflation. In fact, Reuters reports that a food price crisis may be the next stumbling block for emerging economies, even as their bonds and stock markets rally in relief at an easing of the eurozone's debt crisis.

So why are hedge funds still struggling? There is no shortage of themes to play. From traditional energy, to renewable energy, to agribusiness, to commodities, to technology, to medical devices, all the way to nanotechnology.

But the reality is that a lot of managers remain very apprehensive, unwilling to commit significantly to any sector until they see clear signs that the economy is stabilizing and the forces of deflation/ deleveraging have subsided.

In the meantime, the liquidity rally continues and smart money is buying the dips. How long will this go on? As long as the Fed allows banks to borrow cheaply and invest in risk assets all around the world. There will be hiccups along the way, but nothing resembling 2008.

Below, I leave you with Gregory Zuckerman's interview as well as an interview with David Gerstenhaber of Argonaut Capital Management. I don't agree with all of Mr. Gerstenhaber's points, but listen to his thoughts on why businesses are not hiring and investing and why he thinks the main risk remains deflation.