Hedge funds next?

One of the most remarkable features of the ongoing crisis has been its relative lack of impact on the $1.7 trillion hedge funds industry. The dot com bust and weakness of the equity markets at the turn of the century, pushed institutions like pension funds, foundations and endowments, into hedge funds which promised attractive returns. Given their risky investment strategies, high leverage and large exposure to mortgage backed securities, it was natural to expect these private partnerships to be adversely affected by the crisis.

Steve Levitt thinks the good news may not last for too long and their weak balance sheets are obscured by lack of regulation and "lock-in" periods on investments. The "lock-in" periods vary from a quarter to a few years, though generally with quarterly opt-out provisions. The unregulated nature means that hedge funds are not governed by "mark to market" regulations that necessitates margin calls and capital ratio requirements. As the "lock-in" periods expire and redemptions start, Levitt predicts "a string of huge hedge fund failures".

And the signs are unmistakable. Globally the number of hedge funds are shrinking, retrenchments have started in some of the biggest names, and losses are mounting as wealthy investors start heading for the exits. The current year is on the way to becoming the worst ever since the industry erupted into prominence in 1990. However, even as the average hedge fund was down 17.6% during the year till early this week, it performed far better than most other investment avenues.



The falling markets, bans on short trading, tightened standards on prime brokers (who lend shares for short selling, offer advise and assist hedge fund maangers), and the rising tide of regulation, has made many traditional strategies of these "omnipotent vanguard of financial capitalism" unworkable or illegal. The crisis facing the hedge funds lends credence to the long held view by sceptics that far from any special set of trading strategies, these funds just used cheap money to amplify mediocre returns and are simply another cog in the massive debt-dependent financial ecosystem that has emerged in the recent years.



But the extent of their leverage, at three to five times, is far less than the 20 to 30 ratios that investment banks had run up. Given this, the major concern arises from any possibility of a stampede to the exit doors by its high net worth investors and institutions, in particular who face pressures to raise their surpluses and margin calls. In the days ahead, only a spectacular rebound by the financial markets can save runs on many hedge funds.

Update 1
Hedge funds have performed badly in 2008, as indicated by the graph below.