Hedge Fund Pain

Today’s Financial Times details what I’ve mentioned briefly here before: many hedge funds are in trouble.  As a group, they performed terribly in 2008 when compared to their intended goal: to “hedge” against loses in other parts of an investor’s portfolio.  I’ve listened to hedge fund managers boast that they did “great” in 2008 when they “only” lost 20% compared to almost 40% loss by the S&P 500.  They fail to grasp that investors looked to hedge funds to provide gains in these sorts of markets, not to lose less.

In any event, the FT states that this has been the worst year ever for hedge funds, that many are closing, and many are faced with record redemption requests from investors.  All this will continue to put downward pressure on asset prices from an industry that at one time was estimated to control 25% of the US stock market.

Update: this week’s Barron’s has a similar article, Hedge Funds Meet Their Match,

Hedge fund managers, the stars of the investing world for most of this decade, were brought to their knees in the turmoil of 2008. The average fund fell far short of its goal of “absolute returns,” posting an 18% loss through November. Old standby strategies, such as buying some stocks and selling others short, suddenly stopped working. Customers bolted in record numbers. Then, at year’s end, the industry got a black eye for putting money in Bernard Madoff’s black box.

Indeed, the industry is moving into survival mode for 2009 — and many funds won’t make it. The number of hedge funds, which surged in recent years to an estimated 10,000, could eventually fall to about half that, as small, marginal players are sold or go out of business.

The survivors will no longer be able to rely on leverage to goose returns, thanks to the credit crisis. They’ll have to prove that they seriously investigate potential investments. And they will have to make their own operations considerably more transparent. All the while, regulators are sure to be watching over the industry with new vigor.

Unquestionably, hedge funds will have a tougher time winning the outsized returns — and profits for themselves — for which they became famous in recent years.

To their credit, hedge funds did beat the broad market last year; the Standard & Poor’s 500 fell by some 38%. But that’s not an accomplishment the industry can easily ballyhoo. After all, hedge funds long have promoted themselves as vehicles for making money in any kind of market, thereby preserving capital. By simply measuring themselves against the market, hedge funds start to look like mutual funds, and mutual funds charge much lower fees.

A quick comment: if Barron’s is accurate and there are 10,000+ hedge funds, then it is true that there are more hedge funds than publicly traded companies in the US, by almost 2 times!

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