Bloodbath ahead

Big differences in hedge fund performance could put weakest ones on endangered list

The biggest performance dispersion among hedge funds and funds of funds in six years has set the stage for what some predict will be a six-month-long bloodbath.

Sources said they expect the body count to total as many as 2,000 hedge funds and 500 hedge funds of funds between now and the end of March as investors redeem assets from the poorest performers and weakest managers, and move into funds managed by strong, institutionally oriented firms.

Data from Hedge Fund Research Inc., Chicago, showed that for the 12-month period ended June 30, there was a 75 percentage point difference between the average performance of the industry's top and bottom deciles, said Kenneth J. Heinz, president. Further, Mr. Heinz said there was a heightened level of dispersion between managers in the same style categories. And to make matters worse, there was a performance dispersion of 37 percentage points between the average performance of top- and bottom-decile hedge fund-of-funds managers.

“These are the highest performance dispersion rates we've seen in the last six years,” Mr. Heinz said, noting that hedge fund returns within style categories and across the fund universe tended to be very closely correlated from 2002 through August 2007, a period characterized by low volatility, which pushed many hedge fund managers to add leverage to amplify their performance.

The witching hour is nigh, in fact, this week.

Most hedge funds operate on an end-of-quarter deadline for requests from clients to have their money returned. If experts' predictions of very large collective redemptions come true, managers will have to liquidate their holdings en masse, pushing down prices and forcing many smaller hedge funds or those with poor returns out of business. The wave of closures could span six months, likely beginning in earnest in November and December at the end of the typical 45- or 65-day waiting period when fund managers have to return investor cash. Sources said they think the pace of fund consolidation will wind down by the end of the first quarter of 2009.

“Consolidation in the hedge fund industry would not be the least bit surprising, but it's not the first time it has undergone consolidation and liquidation,” Mr. Heinz said. He pointed to HFR analysis of fund liquidation, which as of June 30 was on pace for 700 fund closures in 2008, up 24% from the 563 funds that closed in 2007, but well below the previous high of 848 funds in 2005.

Shattered forecasts

Other sources said HFR's predictions for the remainder of the year will be shattered by the market turmoil of the past 14 months, with several sources certain that 25% of the estimated 10,200 hedge funds in operation as of June 30 will close in the next six months.

“We'll see a tidal wave of hedge fund closures before the end of 2008,” said David C. Saunders, founding managing director of K2 Advisors LLC, Stamford, Conn. K2 manages $7.4 billion in hedge funds of funds.

Mr. Saunders said smaller firms will be hard-pressed to survive a triple whammy: poor performance that has dropped 90% of funds below their high-water marks, resulting in no performance fee income; large redemption requests that will force portfolio liquidations at fire-sale prices, further dropping performance; and rising costs for everything from utilities to accounting, administrative, information and compliance services.

Performance of both hedge funds and funds of funds descended far into negative territory year-to-date through Aug. 31, with performance of the HFRI Hedge Fund Weighted Composite index down 4.85% and the HFRI Hedge Fund of Funds Composite index down 6.35%, according to Hedge Fund Research.

While both indexes' returns were far better than the -11.38% turned in by the Standard & Poor's 500 index for the same time period, in absolute terms, negative returns spell disaster for managers, said Mr. Saunders.

“For many managers of smaller hedge funds and funds of funds, it will take two or three years to recover from these deep losses. Most will not have the luxury of that much time. This kind of environment forces investment officers to really know, in depth, how their staff or their hedge fund-of-funds managers, are selecting underlying funds,” he said.

“There will be a sort of Darwinism process. Only the strongest and largest hedge funds will survive,” agreed Nathanael Benzaken, managing director and head of hedge fund research and selection at Paris-based Lyxor Asset Management SA.

“This year might well be the first year ever that there are more fund closures than launches as investors move their money out of poorer performers. This redemption has to happen. The industry has to correct itself in order to continue its upward trend,” Mr. Benzaken said. Lyxor has $11 billion in managed accounts on its hedge fund platform.

Positive, necessary

Many hedge fund executives, like Messrs. Saunders and Benzaken, consider the coming industry retraction positive and necessary. Observers said the stress of the coming months will reveal the “real” money managers in a crowded industry.

“Sometimes being a hedge fund manager is like being an actor. Here in Southern California, you may talk to a waiter who will insist that he is really an actor. But he is really a waiter who moonlights as an actor. A lot of hedge fund managers are really charlatans moonlighting as money managers,” said Jane Buchan, chief executive officer of Pacific Alternative Asset Management Co., Irvine, Calif. PAAMCO manages $11 billion in hedge funds.

“Significant performance dispersion like the industry is experiencing leads to big winners and big losers,” said Robert Kulperger, vice president-marketing and client service for hedge fund-of-funds and portable alpha manager Northwater Capital Management Inc., Toronto., which manages $4.5 billion in hedge funds of funds.

“A function of this dispersion and the stress it is creating is that you'll be able to see who was operating close to the vest, controlling expenses, and who was extravagant in their spending and compensation. And when it comes to performance, you'll see who was focused on investment management, on market neutrality and creating alpha. And you'll be able to see who was coasting on beta,” Mr. Kulperger said.

Thomas Strauss, managing member, CEO and chief investment officer of Ramius Capital LLC's New York-based $4 billion hedge fund-of-funds group, agreed it's “almost inevitable” that there will be fewer hedge funds six months from now. But he warned against investors panicking about short-term performance without taking a careful look at the quality of their managers.

“Good managers will be given a pass this year (by investors). There are some really good funds that have had a bad year. Triple-A managers who have been in the business for 10 years and have a solid track record are not going to lose their heads overnight. These managers have a good investment process, a solid infrastructure, institutional-quality managers. While it might be tempting to panic about them and think about doing something, it's too easy to make mistakes,” Mr. Strauss said.

Mr. Strauss said many top-tier managers are taking advantage of the difficulties of others by aggressively seeking talented portfolio management teams. “They're out shopping. Good people will be in demand and will be able to stay in the business, although maybe not as independents,” he said.

One positive result of the next six months of turmoil is that hedge fund managers will be forced into giving investors much better terms, said Lyxor's Mr. Benzaken.

“The strongest managers, the ones that survive, will find it very difficult to continue to impose onerous terms like two-year lockups, annual liquidity terms and other restrictions that they don't really need. Distressed managers and those strategies investing in less liquid securities will, of course, need a guarantee of longer-term capital, but other managers don't need this,” Mr. Benzaken said.

Contact Christine Williamson at cwilliamson@pionline.com

Updated with correction