Why hedge funds are dying out

This year is shaping up to be the worst on record for hedge funds, with the average fund down 10%. Managers have sold assets and built up a $600bn pile of cash in case investors pull their money out. Eoin Gleeson examines what's going on.

The hedge fund industry has sold off assets and built up a record $600bn cash pile. What's going on? Eoin Gleeson reports.

What's happening to hedge funds?

Monday marked the final day of this year for many investors to withdraw their money from hedge funds in time for the end of December, reports the FT, and anecdotal evidence suggests that withdrawals could be higher than ever. Quite apart from the awful conditions in the rest of the markets, this year is shaping up to be the worst on record for hedge funds, with the average fund down 10%, according to Hedge Fund Research. More than 350 funds closed in the first half, and the worry now is that, with investors panicking, a spate of hurried sales could end up closing hundreds more. The industry is already bracing itself, selling off assets to build up a record $600bn cash pile, to meet potential redemptions, according to Citigroup. That's the equivalent of $1 for every $3 under management. By the end of the year, another 700 hedge funds could hit the wall, according to Hedge Fund Research. Those that have piled into the popular strategies of recent years, especially those focused on China, are due spectacular redemptions, one manager told Reuters.

Why are things so bad?

The recent ban on short selling has stung hedge funds in a big way. The US financial watchdog, the SEC, banned short sales on 15% of the stocks in the S&P 500, paralysing many hedge funds that rely on betting on share prices falling. Many also expect the ban which was originally a short-term move to be extended for another 30 days past the 2 October deadline. That will give investors more than enough to time to worry that these bans will kill the business model of many hedge funds. But even if hedge funds had a free reign at the moment, they would struggle to fund their trades anyway. As credit tightens across the money markets, prime brokers, the banks who lend money and stocks to hedge funds and keep track of their trades, have turned on hedge funds charging a fortune for loans and extending them little or no credit. The cost of borrowing on convertible bonds which can be converted into shares and are essential to hedge funds looking to exploit overvalued stocks has risen 100% in recent weeks, while the cost of loans on stocks has jumped by 20% to 30%. "We've become hesitant, gun-shy," Hilary Kramer of the GreenTech Research hedge fund confided to Bloomberg.

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Isn't everyone suffering?

Certainly, most investors are having a tough time at the moment, with markets across the globe falling. But the whole point of hedge funds was that they were supposed to be able to make money in good times and bad. The search for 'alpha' value added by a fund manager's skill rather than pure luck was used to justify their hefty fees. The line they sold investors was that by investing in a wider range of assets and by using more strategies than conventional funds, they could make a return regardless of the market conditions. It was a claim that until recently they were able to stand by. Since 1990, the industry has posted one losing year: 2002, when funds dropped an average 1.45%, according to Hedge Fund Research. The S&P 500 plunged 22% that year.

So that sounds good, right?

Yes, but those figures suffer from "survivor bias", in that they don't take account of all the funds that shut down or went to the wall in the meantime half of all hedge funds fail in the first five years. And now that we've hit a real downturn the kind you want your hedge fund manager to guard against they've been found wanting. Not a single strategy made money last month, reports Louise Armitstead in The Daily Telegraph. Also, as the hype around the hedge fund industry grew, and more funds were launched, many ended up piling into the same assets and using the same strategies as one another, in a manner not hugely different from the conventional fund industry. Most importantly of all, much of the outsize returns that were put down to alpha were simply down to leverage, pure and simple. Borrowing big to take big bets might work fine when markets are rising. But it can be ruinous when things go against you something that many managers are finding out now the tide of easy credit has gone out.

What will be left of the hedge fund industry?

The hedge fund industry won't vanish. But many popular strategies, such as those based on leverage, will have to go by the wayside for now, and the outsize fees usually 2% upfront and 20% of returns will have to fall. RAB Capital has frozen redemptions on its Special Situations fund for three years, in return for management fees being cut in half. Like many beneficiaries of the credit boom, the industry will be far smaller once the bust is over.

Can you make money in good times and bad?

Not, it seems, if you're relying on the average fund manager. Last year only 25% of the funds in the UK All Companies sector beat the FTSE All Share. Absolute-return funds, which like hedge funds aim to make money in good times and bad, have done somewhat better than that. Of the seven funds that have track records longer than a year, all are in positive territory over the past 12 months, with an average return of 5%. This compares with an average fall of 21% in the UK All Companies sector. However, even then, only two of the funds within the sector would have beaten cash the BlackRock UK Absolute Alpha and Threadneedle Absolute Return funds. So if you really want to avoid capital loss, a savings account is hard to beat.

Eoin came to Money Week in 2006 having graduated with a MLitt in economics from Trinity College, Dublin. He taught economic history for two years at Trinity, while researching a thesis on how herd behaviour destroys financial markets.

Eoin acts as managing editor of MoneyWeek's newsletters.