HEDGE FUNDS: Downward fall

A number of hedge funds didn’t survive by the market instability caused by the sub-prime crisis, begging the question: are they as robust as is commonly thought? By Kristen Paech

The selling point of hedge funds, and the characteristic that allows
them to justify their significant fees when compared with the long-only
world, is largely their ‘absolute return’ tag. In essence, many hedge
funds are marketed on their ability to make investors money even when
markets are falling.

Yet during the sub-prime related market dip, many hedge funds struggled
to stay above water and even those with no exposure to sub-prime
mortgage backed securities were hit by the contagion that spread across
all of the financial markets.
Two hedge funds run by Bear Stearns and one managed by Australia’s
Basis Capital have filed for bankruptcy and others run by Goldman
Sachs, Cheyne Capital Management and Tykhe Capital have since run into

The HFRI Fund Weighted Composite Index was down 1.3% in August, while
the S&P 500 index was up 1.5%; however, a bounce-back in September
saw the HFR index rise an estimated 2.98%.

So was August just a blip on a fairly impressive track record for the
hedge fund industry as a whole? Both managers and consultants are
staunch in their defence.

“The performance in August does not negate in any form or manner the
absolute return mandate of the hedge fund industry,” says Taco
Sieburgh, director of research at hedge fund consultancy Liability

Stephen Oxley, managing director of PAAMCO Europe, adds: “I really
think it’s a mistake to isolate one or two months and try from that to
make general conclusions about the longer term performance of these
strategies. We now have a ten-year track record for hedge fund returns
and if you look at them over the longer term they do justify their

Winners and losers

It’s worth mentioning that hedge funds made money in June and July when
the S&P declined, and an exceptionally bad August has not
significantly impaired the ample year-to-date returns. The HFR Fund
Weighted Composite Index is up 9.14% year-to-date, while the HFR Fund
of Funds Composite Index stands at 8.45%.

Indeed, while on average hedge funds underperformed in August, funds
that were set up specifically to take advantage of credit dislocation,
such as the US$4.5bn Paulson Credit Opportunities Fund, have profited

The fund, launched last year to bet against sub-prime, is reportedly up
410% year-to-date after soaring 26.67% in August, while a second fund,
the $2.3bn Credit Opportunities II, rose 32% and is up 229.67%
“Those funds took a directional play on sub-prime, assuming there would
be a sub-prime crisis and have made super normal returns,” says David
Aldrich, a managing director at The Bank of New York Mellon.

“The Paulson funds are great examples of how you can use hedge fund vehicles to profit from major moves in the market.”
But for all the big winners, there were just as many big losers.

Some of the worst performing strategies included emerging markets,
global macro, managed futures and event-driven funds, but perhaps the
strategy that looked worst on a relative basis was long/short equity.

“In August, a big part of the losses came from the equity long/short
managers while the equity market was actually overall positive in
August,” says Yannis Procopis, deputy CIO of CM Advisors.

Shake out

“There was a huge sell-off at the end of July, which continued into
August, before recovering at the end if the month, and that hugely
volatile environment proved very difficult for many equity long/short

There have been about 20 high-profile closures linked to
mortgage-backed sub-prime directly, with Sentinel in Europe having a
knock-on effect on others in the marketplace, including Capital Fund

Donnacha Loughrey, portfolio manager, alternative investments at KBC
Asset Management, expects to see some consolidation in the industry
going forward.

“We still see the attrition rate in hedge funds running at about 10%
per annum but some of the smaller hedge funds that are independent and
have been hit hard by the tighter credit conditions will probably be
bought by one of the larger investment banks or by a traditional fund
management business, or simply close,” he says.

“There’s going to be a shake out, more than the 20 or so funds we’ve
seen close, but I’d expect that performance in September has probably
eased a lot of the redemption fears that people were anticipating in
November or December, so I wouldn’t expect a lot of failures from the
broader hedge fund universe.”

The nature of the instruments in which hedge funds invest further
complicates the ability to valuate assets and positions until they are

Sitting on losses

Julian Korek, a founding member of Kinetic, which provides accountancy
and consultancy services to the investment management industry,
comments: “The absence of liquidity means there’s no willing buyer of
the instruments that many hedge funds are holding, and so it is hard to
establish a price. Funds who have kept these instruments at book value
or last counterparty valuation may be sitting potentially large losses,
once a market for these instruments reappears. There may be many more
skeletons in the cupboards of a lot of hedge funds.”

When high net worth and institutional investors commit capital to hedge funds, they are fully aware of the risks that entail.
However, what the backlash over hedge fund returns during the sub-prime
crisis has demonstrated is that it is less about how they performed on
an absolute basis and more about how they performed relative to
investors’ expectations.

In this respect, it seems they fell well short of the mark.

"They have performed better than traditional strategies – they’ve had
less volatility and they have been able to demonstrate something of the
hedge,” says Peter Harrison, CEO of MPC Investors.

“However, they have been far too correlated and they have performed less well than most people expected they should do.”
The make-up of the fee structure for hedge funds is such that many
funds now face months if not years without a performance fee.

While many do not have a hurdle rate, and are rather measured against zero or cash, nearly all of them have high water marks.

High water marks are measured annually and if a manager underperforms
in one year, they have to make back the performance the following year
before they can start charging a performance fee again.

“The average fund wouldn’t have generated a performance fee in July or
August because they’re probably about 3% below their high water mark,
but depending on the strategy a lot of these funds can make that back
quite quickly,” says Loughrey.
Procopis adds: “Even with the August losses, as an industry it’s still
definitely above its high water mark from the beginning of the year.
August was difficult but a lot of the losses were already made back in

But for those funds that suffered more severe losses, the sub-prime crisis may just be the death of them.

“A lot of funds lost 20 or 30%, so they are now so far below their high
water mark that it’s not worth carrying on,” says

“This is the incentive structure working correctly; if you lose your
clients’ money you don’t earn any fees until such time that you start
making your clients money again.”

©  fe November 2007



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