By Laurence Fletcher
Hedge funds are set to return to their roots as niche products for the happy few as they have been unable to deliver the gleaming returns they were promising ever since the start of the credit crisis.
Hedge fund managers have long been flaunting alpha — returns down to their skills to beat markets by using advanced investment techniques — but many were caught short just as any other investor in this year's protracted downturn.
The industry now faces rapid shrinkage driven by losses of more than 20 percent, as measured by Hedge Fund Research's daily HFRX index, and redemptions that are predicted at somewhere between "large" and "catastrophic".
"Eighty percent of the hedge fund sector will not be here in three to four months," Robert McAdie, a credit strategist at Barclays Capital, said at a recent briefing. "Levered strategies are dead in this environment."
Funds have delivered worst-ever losses of 17.70 percent in the 11 months to November, according to Hedge Fund Research, as stocks have slumped and volatility has surged.
The first hedge fund was set up in 1949 by Alfred Winslow Jones with the aim of hedging a portfolio of longs (bets on rising prices) with a portfolio of shorts (bets on falling prices). It was followed by a range of other funds in the 1960s, including legendary manager George Soros's Quantum fund.
In the early days hedge funds tended to be run by some of the brightest stars in the financial services industry, who had a "go anywhere" remit and often the best access to brokers.
TWO IS A CROWD
However, hedge funds' early "crazy" spirit, as Eclectica Asset Management's Hugh Hendry has called it, has been diluted by a huge wave of investor flows that made it easier for less gifted managers to piggy-back on the real stars.
During the boom years of 2003-to-2007 assets swelled to as much as $2.6 trillion, and often two traders and a terminal were able to set up a long-short equity fund and quickly raise $50 million or $100 million from eager investors.
Pay cheques of $1 billion or even more for the top managers made headlines, and they charged hefty fees.
The credit crisis may have revealed what many were already suspecting — that in many cases the prized alpha that many funds were supposedly producing was in fact beta — or ordinary market performance — repackaged.
Gains of nearly 20 percent in 2003 and roughly 10 percent a year in 2004-2007 coincided with rising equity markets.
With expectations of positive returns in all markets now shattered and redemptions flooding in, the industry is set to become much smaller again.
Such a position could ultimately prove much healthier for the industry.
"They say profits cover problems, but there have been much fewer profits in 2008 and many of the problems are starting to be more apparent," says Odi Lahav, vice president at rating agency Moody's alternative investment group.
Looking into 2009, it seems that only a relatively small number of managers will be able to produce genuine alpha — the same situation as in previous years, although this time they will now make up a much greater share of the industry.
"But it grew very fast and there were a lot of managers out there that probably shouldn't have been hedge fund managers so the ability to produce alpha was both more difficult and also not a foregone conclusion," said Moody's Lahav.
The current cull could put the hedge fund industry on a much sounder platform for the growth in demand that will eventually emerge for funds able to use more than one investment tool.
"The hedge funds and fund of hedge funds that make it through 2009 will be in a strong position to benefit from the re-emergence of the alternative investment industry," said Cem Habib, fund of hedge funds manager at Altedge Capital.
But "the hedge fund industry might look significantly different in 2010 due to structural and regulatory changes."
