Even Hedge Funds Are Hurting

The easy bull-market ride is over, capital has dried up, and even the S&P 500 index is outperforming most hedge funds

by Ben Levisohn

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The idea for "Even Hedge Funds Are Hurting" came from Stamatios Kanellakis. A marketing, customer loyalty, and innovation analyst living in Brooklyn, N.Y., Stamatios has been an avid reader of BusinessWeek since college.

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It's the summer of hedge fund discontent. Just as managers seemed on the verge of making back their losses from a less-than-scintillating first six months of 2008, July rolls around. At the end of the month, the HFRX Global Strategy Index, down about 1% for the year at the end of June, shed another 2.8%. Not much of a way to earn your 2% fee and 20% performance bonus. To make matters worse, the Standard & Poor's 500-stock index, which finished down 1% in July, trumped the funds. Even some superstar managers suffered, including Harbinger Capital Partners' Phil Falcone, whose flagship fund lost 16% in July when his buy oil/sell financials strategy suddenly fell apart midmonth (to be fair, Falcone is still up 23% on the year).

Many hedge fund managers are struggling to adapt to a radically different environment. Gone is the gently upward slope of the bull market. Gone, too, is the easy credit that made it simple to leverage small gains into large ones. And gone are complacent investors willing to hand over their millions (BusinessWeek.com, 8/4/08) to the nearest hot-shot financial whiz. Today, hedge fund managers must hold worried investors' hands and scrutinize every bank they do business with, all the while earning outsize returns that clients demand. "Hedge funds will find [the environment] difficult unless they're very good at maintaining the returns," says CEO Lee Giovannetti of consulting firm Consulting Services Group. "We should see a significant shrinkage in the number of funds out there."

Investors appear to agree. They've been quick to jump ship from underperforming funds. Relative-value funds, which exploit price differences between similar assets, suffered $3.6 billion in outflows during the first half of the year. At least one, Lincoln Park Asset Management, delayed the launch of its credit arbitrage fund. During the first three months of 2008, 170 funds closed, an increase of roughly 30% over the year-earlier period. At the same time, investors closed their wallets, as inflows dropped 79% year-over-year, to a paltry $12.5 billion, with more than half going to the top-performing macro strategy.

Throwing in the Towel

As a result, managers are on an increasingly short leash. It's one thing to shutter a fund that's down 30%. But even managers who net positive returns are at risk of being closed down if they can't post big gains. Exhibit A: Carlyle Group pulled the plug on its Carlyle-Blue Wave Partners Management fund despite a 2% gain this year, which wasn't enough to earn back last year's losses or cover the cost of operating the fund.

Fund problems have been exacerbated by tight credit caused by banks' unwillingness to lend money. When money was cheap, managers could borrow 10 times their assets, which would boost returns by 10 times, as well. The gains would more than cover the interest on the loans. A manager would identify a stable spread between two assets—say, a convertible bond and a common stock—and would short one and buy the other. Multiply a small gain of 1% by 10, and you have happy investors. Now, however, cash is king. Hedge funds dependent on easy credit are closing up shop.

But not everyone is suffering. Another hedge fund barometer, the Greenwich Global Hedge Fund Index, showed that despite being slightly negative at midyear, half of the funds had positive returns. Opportunities abound. Bonds, mortgage-backed securities, and other fixed-income products are selling at bargain prices. Market volatility creates the moves that true hedgers need to outperform the market and their own benchmarks. "The opportunity for hedge funds has been as good, if not better, than any period I'm aware of," says TMF Capital Management's Michael Harron, who has been in the business for more than 25 years.