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Thursday, 2 October 2008


An increasing number of hedge funds are telling customers they cannot have their money back just now (though not a new practise) as rising withdrawals on top of problems in getting collateral back from prime brokerages’ rehypothecations (such as most notably at Lehman Brothers), plus talk of the past year being especially bad for hedge funds’ performance – are all supposedly hitting retail and institutional confidence in hedge funds. Hedge fund performance at minus 10% is described as “shocking!”, but as many have done better than that as have done worse than that.
There are at least 3 thousand relatively reputable hedge funds. They are not a homogeneous instrument or asset class that performs as one. When the stock market has fallen 25% and given the enormous sensitivity of hedge funds because of their ultra-high leveraging, and their liquidity mix of long and short term funds, -10%. measured at the point of maximum pessimism or market floor, is really a good performance! But, it is only the aggregate across the industry. Many funds have performed much worse. The fear is that hedge fund liquidations that could surpass 2005, when roughly 10% of Hedges closed. Leverage is harder to get, limiting absolute returns (losses or profits), though 20-25% of hedge fund assets appear to be in cash and treasuries just now anyway.
Institutional investors in hedge funds have their own clients’ anxieties and any losses kill performance fees. Losses can invite liquidation if managers reckon the road back to previous high water marks (carryforward provisions and hurdle rates) before they can charge performance fees is too hard or too long. For HNWs and other investors able to take a longer view, then hedge funds may well be considered a great place to be to buy distressed assets at fire-sale prices, especially financial assets that may soon become more standardised, commoditised, easier to net clear and credit-worthy again. Not so, however, if the roll-over leveraging by which hedge funds counter-intuitively stake-out volatile markets looking for spectacular short to medium term gains. Macro-funds have outperformed others – they do not just analyze the technical market risk indicators but base their strategy on macro-economic risk drivers and think about cycles.
Anyone not wanting to be invested in an underperforming hedge fund right now can normally withdraw on the first day of any quarter? It may be that in exchange for refusing to permit investors to withdraw hedge funds have ensured that investors funds are placed in safe money amrket funds. The hedge fund industry is variously said to have $2tn or $3tn under management. There may be a total of 56,000 funds (19,800 “distinct” hedge fund and fund of funds of which 15,400 report performance, and 13,675 single manager funds of which 10,200 reported, and 6,100 funds of funds). 40% of these are less than 3 years old. 90% of closures tend to be single-manager funds and the attrition among new funds is bound to be high, maybe 60%, which is typical of all new start-ups. Note that of single manager funds, two thirds are domiciled off-shore. Therefore, the estimate that 2,000 hedge funds and 500 hedge funds of funds may be at death’s door is not fanciful, although less than 200 have gone in Q1-Q3 of 2008.
I doubt that a wave of clients requesting their money back as predicted over the next 6 months will pull down aset prices simply because in today’s volatile markets 6 months is a very long time. Also, the range has never been wider between good and bad performing funds. Therefore, investors may shift from fund to fund more that withdraw entirely from hedge fund investments, though not necessarily from small to large given that power to leverage and short-selling are not the basis for performance that it was before August 2007. A sign of this may have been Lehman Bros selling Neuberger Berman for $2.15bn when its book and peer value was $8bn. People involved described the process of persuading them to sign on to the deal as akin to "herding cats."
A hedge fund shake out will, I suggest, not be brutal, if as before 90% of closures are single manager funds. We might know more about the systemic risk of hedge fund closures if the industry was regulated. In the UK, the FSA regulates hedge fund but not regulate the funds themselves (despite as win most major countries these are open to retail investors). The FSA has long promised some thematic work on the adequacy of systems and controls in hedge fund managers, but may be waiting to see what the SEC does. The FSA said, "We do not and cannot regulate the hedge funds themselves or set standards for them to achieve. However, all firms based in London, including the hedge fund managers, must take reasonable care to maintain systems and controls appropriate to their business. Hedge fund managers should be properly qualified and controlled when undertaking investment activities for their client fund. Any hedge fund manager in breach of these standards would be in breach of the rules." The rules are basically the same for any investment intermediaries, advisors and brokers.
SEC chairman Christopher Cox has sought more regulatory supervision, but been overturned in federal court in June 2006. Concerns have been voiced by all and sundry, including a few hedge funds, and not least in Europe, such as Angela Merkel no less, about the lack of transparency as well as inordinate fast growth of hedge funds. Under the SEC's proposals of 2004, hedge funds would have to register and open their books to the SEC. Mr Cox told the Senate Banking Committee that without regulation "the potential for retail investors to be harmed by hedge fund risk" (is a serious concern), and "the growth in hedge fund fraud that we have seen accompany the growth in hedge funds implicates the very basic responsibility of the SEC to protect investors from fraud, unfair dealing and market manipulation…;" "These are not investments for Mom and Pop." Currently, investors must have assets worth at least $1m, but Cox wanted this upped to $1.5m. Since then hedge fund assets grew fivefold. But, while at that time Mr Cox's demands were not supported by all other SEC commissioners, or by the Fed’s Ben Bernanke (who opted for free market discipline in place of constricting rules), it must now be easy to get SEC regulatory oversight passed.
Ten days ago EU lawmakers were set to adopt a report calling on EU Internal Market Commissioner, Charlie McCreevy, to come forward with a legislative proposal to toughen oversight of hedge funds and private equity companies. But, in prepared remarks to the European Parliament, McCreevy, said, "I don't believe it is necessary at this stage to tar hedge funds and private equity with the same brush as we use for the regulated sector." This surprising statement implies a backwards or relativist view of the virtues of regulation?

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