Knocked down but recovering

Dubai: The year 2008 was a disaster for the hedge fund industry.

It shouldn't come as a surprise to anyone. After all, the onset of the global credit crisis and the resulting liquidity freeze had negatively affected nearly all legal investment channels.

But for hedge funds, the hits did not just come in the form of plummeting equity, commodity and real estate prices. The industry came under attack from regulators, public opinion and even the global business community for what they viewed as its role in exacerbating the crisis.

Investors started pulling their money out, a process referred to in the industry as redemption, and at an increasingly alarming rate which would peak in the fourth quarter.

Essentially, many began questioning why they were paying management fees of 2 per cent, and sometimes more, plus another 20 to 30 per cent of their profits, if they realised any that year, for net returns that fell below average returns at the time on fixed-income and equity assets.

For funds that performed well, investors withdrew their money for precisely that reason. They needed the cash as credit markets quickly dried up.

On average, hedge funds would go on to close the year down almost 20 per cent, according to Chicago-based Hedge Fund Research (HFR) figures. Funds of funds lost 18 per cent on average, according to Standard and Poor's (S&P) research.

Margin calls

As redemptions rose, so did margin calls by brokers attempting to lower their exposure to the relatively higher risk investment strategies employed by hedge funds. If crashing equity markets did not already force those calls, lenders were simply requiring the funds to cover for more of the money they borrowed.

Borrowing more money to satisfy the brokers in an increasingly illiquid market was not an option for funds that were sometimes already 30 per cent or more in the red for the year. So managers began almost indiscriminately selling their assets, especially those which managed to hold their values, forcing equity and debt markets down even lower.

For those who could not meet their margin call obligations, brokerages spared no time in liquidating their assets and putting them out of business, all of about 2,500 of them.

Tom Evans, executive vice president for the New York-based Permal Group, one of the oldest and largest funds of hedge funds with $20 billion in assets under management, says now might be the most opportune time for investing in hedge funds.

Evans came through Dubai in early October as his fund was beginning a series of investor road-shows in the Middle East.

"Although the hedge fund industry got a lot of bad press [in the past year], it actually did much better than just about any other asset class," Evans says.

Compared with the hedge fund and fund of funds losses just under 20 per cent, the S&P 500 Index lost 38.5 per cent, while the S&P Global 1,200 dropped by 40.1 per cent in 2008. The industry took perhaps the strongest hits in September 2008, when regulators all over the world, lead by the US Securities and Exchange Commission banned short-selling on bank securities almost immediately after the collapse of Lehman Brothers.

The ban in the US would last for less than a month, but in the UK, for example, it was not lifted until January of this year. Australia maintained its ban through late May.

September 2008 was also the last month of the third quarter, giving a chance to panicking investors to put in redemption notices. Despite the fact most hedge funds raised their minimum notification periods to 45 or more days prior to the end of the quarter, the fourth quarter of the year registered a record for investor redemptions of $152 billion, according to HFR.

For Permal, the fund peaked in June 2008 at $38 billion. "The thing that hurt us last year through September was that our performance was very good, especially relative to a lot of other products including equity indices and fixed-income indices," says Evans. "And when people get margin calls, they don't liquidate something that's down 80 per cent, they liquidate the thing that still has 90 or 95 per cent of its value. That's what happened to hedge funds in general starting in September.

The first half of 2009 saw continued redemption activity to the tune of $146 billion more being withdrawn, although at a noticeably slower pace each progressing month.

In mid-October, HFR released its figures for the third quarter, showing the first net gain for the industry in a year at $1.1 billion. Still, the average hedge fund gained just 7 per cent on the quarter and 17 per cent on the year compared with the S&P 500 at 16 per cent and 19 per cent over the same respective periods.

"We needed a shakeout like everything else in this great big bubble," Evans says. "Ten thousand hedge funds with $2 trillion in assets were overdone. Just like 50 times leverage for the big banks of the world was overdone and like real estate and commodity prices. We needed a good correction and we got it."

Evans says it is no coincidence investors are returning at a time when global equity markets have recorded strong recovery regardless of the quality of individual securities or indices.

The S&P Emerging Markets Index is up around 80 per cent from its low, while Merrill Lynch's High Yield Master II Index for US junk bonds is up 50 per cent. "Everything went up, the good, bad and the ugly," says Evans, adding managers can now differentiate between high and low quality securities and invest accordingly, entering into long positions on the good and into short positions on the bad.

"The hedge world today is in probably the best space it has been in two years to make money," he adds.

The time may be right for making money but regulators on both sides of the Atlantic have also decided it is right for tighter regulation. Soon, hedge funds could be required to register with the financial market regulators and disclose information regarding their assets, and investment positions and strategies, even if on a confidential basis.

Regulators and industry analysts now rely on statistics and research from sources such as HFR because of the lack of disclosure requirements. But that's another story for another day.

Until then, and while the return of investors and cash is signalling its emergence from its worst year ever, the industry may want to start hedging now against its long running bet on light regulation.

Glossary

Hedge fund: A pool of private money that gets invested in stocks, bonds or commodities that often use relatively higher-risk strategies such as short-selling and investing in financial derivatives. High minimum-investment requirements limit investor participation but help the funds avoid government regulation regarding leverage, short-selling and minimum liquidity requirements. Hedge funds typically charge a 2 per cent management fee and 20 per cent of profits.

Fund of hedge funds: A pool of private money that gets invested in a portfolio of hedge funds. The increase in diversification lowers investor risk but tends to cost an additional 1 per cent for management and some charge 10 per cent of profits.

Leverage: Borrowed money. Hedge funds typically deal with brokers to direct their investments. They also borrow money from those brokers to increase the size of their investments and maximise profit. For example a fund manager may wish to purchase $10 million worth of stock using $3 million of the investor's capital and $7 million of borrowed funds from the broker.

Redemption: Investor "cashing-out." Most hedge funds require investors to invest for a minimum of three months and some two years. Fees can be imposed for early withdrawal. Hedge funds and funds of funds allow investors to withdraw their money on either a quarterly or monthly basis. They can also impose a limit on how much can be withdrawn at once.

Margin call: A broker who has lent a hedge fund money to purchase stock, for example, uses the asset purchased as collateral for the loan. Once the net value of the asset (current value minus the loan amount) declines below a certain level, the broker requires the fund to deposit more money to cover the decline and maintain a minimum contribution from the fund. For example: a $10 million stock purchase is financed using $7 million of the broker's money and $3 million of the fund's money. The broker has set a minimum margin of $1.5 million, meaning if the value of the stock declines to $8 million, the fund's position is reduced to $1 million and must find a way to raise an additional $500,000 to cover the loss.

Long position or ‘going long': Purchasing an asset with an intent to profit from selling it at a higher price.

Short position or "going short": borrowing an asset, such as a stock, from a lender, such as an institutional investor, and selling it immediately. The investor's intent is to buy it back in the future when its price drops, return it to the lender, and keep the resulting profit. For example: a fund manager borrows $1 million worth of shares from a broker and sells immediately for $1 million. If the value of the shares drops to $800,000, the fund buys back those shares, returns them to the broker and pockets $200,000.