Choose your hedge funds with care

Some have gone quietly whilst others have blown up in spectular style. And there are plenty of good reasons why more hedge funds are destined to go the way of the Dodo and the dotcoms.

Perhaps the biggest victims of the extraordinary events of the last week greater even than shareholders of Bear Stearns, who have at least been promised $2 a share will be the hedge-fund industry. Over the last month or so, several hedge funds per week have been either spectacularly blowing up, like Peloton, or quietly throwing in the towel. One London-based fund recently sold out to a larger US group, while bankers tell me that dozens of others are eagerly seeking buyers.

There are plenty of good reasons why so many hedge funds are destined to go the way of the Dodo and the dotcoms. The first is that so many have not performed very well. Many have been badly caught out by the market volatility. Merger arbitrage funds, for example, which try to bet on the outcome of deals, were caught out by the collapse of several planned mergers and the almost complete absence of deal activity. Many equity funds have struggled to cope with the increased volatility. So far this year, the average hedge fund is flat, according to Hedge Fund Research. That may be a better performance than the stockmarket, but it is not as good a performance as a high-interest bank account and you don't pay high fees on a bank account.

That points to the second big problem. Investors are becoming increasingly skittish. Funds that don't perform are seeing a rise in redemptions. Many investors are beginning to wonder if they wouldn't be better sitting out the current volatility by putting their money into cash. For smaller funds, any pick-up in redemptions could unnerve other investors, leading to a run on the fund. True, most funds are protected by long lock-up periods often up to three months. And often, funds receive redemption notices that investors don't act on. But any fund that thinks it may be vulnerable to heavy redemptions will want to sell up before it finds itself caught in a death spiral that leaves its founders left with nothing.

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And that's the third problem: the capital is not the only thing that can walk out the door when things start going wrong in these businesses. So too can the staff. Hedge funds may be great places to work when things are going well, but they are not so attractive when things start going wrong. A hedge fund these days needs to have about $200m under management before it starts to make decent money for its founders and employees, according to prime brokers who service the industry. And even that depends on making reasonable performance fees.

Even then, it's a constant battle to raise new funds since few investors want to invest with such small outfits. In the current climate, any fund with less than $1bn under management is likely to be asking itself whether the game is worth the candle.

To this list must now be added another problem. Banks are increasingly refusing to finance hedge-fund activity. Last week I wrote about the problems in the repo market problems that shortly afterwards led to the collapse of Bear Stearns. This week, the repo market has effectively shut down for illiquid assets such as mortgage-backed securities, which are widely owned by hedge funds. The reason for this is partly technical, since the collapse of various hedge funds and structured investment vehicles over the last few weeks has led to a glut of assets that no one wants to buy. But another reason is that the US Federal Reserve has effectively removed from the banks any incentive to keep financing these assets.

Until last week, assets that the banks refused to finance would boomerang onto their own balance sheets, where they might remain stuck. But now the Fed has offered to accept up to $400bn of mortgage assets as collateral for its own repo operations, which means the banks no longer mind too much if they get stuck with mortgage securities. They can swap them with the Fed for Treasury bonds. The Fed's bail out of investment banks has effectively hung leveraged credit hedge funds out to dry.

That does not mean that all hedge funds are doomed. As in the dotcom boom, the collapse of lots of small companies did not mean the internet was not a significant innovation. Far from it. I still think that some of the biggest and most established hedge funds offer some of the best places to house cash during the credit crisis. Some of the listed hedge funds, such as Brevan Howard's BH Macro fund, or Ashmore's Global Opportunities, or Marshall Wace's MW Tops, offer unusual strategies for making money in tough markets. But the key is to choose your funds with care.

Simon Nixon is executive editor of

Simon Nixon

Simon is the chief leader writer and columnist at The Times and previous to that, he was at The Wall Street Journal for 9 years as the chief European commentator. Simon also wrote for Reuters Breakingviews as the Executive Editor earlier in his career. Simon covers personal finance topics such as property, the economy and other areas for example stockmarkets and funds.