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The easy bull-market ride is over, capital has dried up, and even the S&P 500 index is outperforming most hedge funds
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.
With markets gyrating wildly as they fall into bear-market territory, funds that short market drops one day and catch bounces the next are thriving. These types of funds—whether quantitative, with computer programs making trade decisions, or discretionary, with a manager choosing what trades to make—saw inflows of more than $11 billion during the first half of the year. It's not difficult to see why. When they get it right—like Pierre Villeneuve's quantitative Mapleridge Capital, which has produced 15% returns this year and was up about 2% in July—they get it very right. "We relish the volatility," Villeneuve says.
In the credit markets, cut-rate mortgage-backed securities, collateralized debt obligations, and other hard-to-price debt are available at fire-sale prices for the manager with the expertise and the cash to take them on. It's a far cry from before the crunch, when many funds cared little about risk and concentrated only on the spread between the price of borrowing and the interest rate at which they could lend. These fund managers are not having fun in this environment.
Funds with money to spend, however, are trawling the wreckage, searching for the asset they can purchase for 10¢ on the dollar and sell for 25¢, says Niket Patankar, CEO of research and consulting firm Adventity. Or instead of buying cheap debt, cash-heavy funds can do the lending themselves, with yields sometimes three to five percentage points higher than just two years ago. "It has changed so dramatically that pricing has come to where we can buy [assets]," says Kjerstin Hatch, portfolio manager at asset-backed lender Madison Capital Management. "It's a lot more satisfying to work hard and get good deals done."
Scrutinizing Prime Brokers
But no matter what a fund's performance—good, bad, or just plain mediocre—all managers are keeping a close eye on the banks that act as the funds' prime brokers. The big investment banks perform multiple roles for hedge funds: as bankers, holders of hedge fund assets, even lenders of stocks the hedge funds short. And there's big trouble if a bank goes under. In the past, the stability of prime brokers was rarely questioned, but fund managers caught a fright in March, when Bear Stearns nearly went bust.
Bear happened to be Cutler Capital Management's prime broker. Cutler President David Grenier experienced the uncomfortable sensation that comes when a fund's bank is teetering on the edge. What happens to assets? What about lines of credit? When the rumors of Bear's impending demise hit, Grenier could do little but place daily phone calls to his contact at the bank and take comfort in the fact that his trades were still going through.
It all turned out fine—Cutler got a new prime broker when JPMorgan (JPM) stepped in to buy Bear. Now hedge fund managers aren't taking their prime brokers for granted. They're spending more time checking their contingency plans. They're making sure they have their insurance policies up to date and have backup relationships. "The biggest thing is fear and how you deal with it," Grenier says.