Monday, January 19, 2009

Black swan year for hedge funds?

One of the most dramatic developments in the financial markets this decade, with profound consequences, has been the emergence of hedge funds, which has been chronicled in an excellent article in the NYT. Once so few in number that "they represented a boutique industry populated by a rarefied group of specialists", today there are around 10,000 hedge funds, compared with around 3,000 a decade ago and just a few hundred two decades ago, whereas the assets held by hedge funds surged to nearly $2 trillion as of the start of 2008, from $375 billion in 1998.

Hedge funds, which invests in a widely diverse set of areas like bonds, real estate, mines, aircraft and small-business loans, offerring spectacular double digit returns, had become a preferred investment vehicle for not only wealthy individuals, but also pension funds, endowments and charities. They use bank financing to leverage their assets under management and thereby magnify their returns, and in turn offer handsome returns for the Wall Street banks. To top it all, they operated in a largely unregulated environment, with little or no transparency and investment disclosure requirements (this lack of regulation means that there is no way of knowing the value of funds’ assets, how much money they borrow, or even how many funds there are). And for all this, the hedge fund managers earn lucrative fees, typically charging 20% of profits, besides a flat 2% of total funds as management fees, all of which taxed as capital gains at just 15%.

As the sub-prime meltdown started and a credit squeeze ensued, the hedge funds were caught between falling asset values and deleveraging banks (the capital of most of the regular investors were locked in for longer time periods), with catastrophic results. Two out of three hedge funds lost money last year, while the average fund lost 18%, and of the funds that lost money, the average loss was 29%. The graphic below tells the story.

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