Is the Heyday of Hedge Funds Over?

Pity the poor hedge fund manager. The markets have gotten so treacherous of late that most are not likely to see as much in years past from their 20% of the upside fees, but 2% on a big fund isn’t too shabby either.

However, the bigger pressure comes from the fact that plain-vanilla, low cost strategies have been doing much better of late. If this sort of pattern continues, the seemingly endless flow of cash into the sector may not simply slow, but could actually reverse. Just as real estate Sam Zell’s sale of his Equity Office Trust in February 2007 to Blackstone at a record low capitalization rate (low cap rate = high valuation) represented a market peak, so to may have the IPO of hedge fund Fortress, which went public the same month. Its price has fallen 50% since then.

This article in the Wall Street Journal describes how hedge funds with simpler strategies are performing better and attracting more funds. But it fails to mention that these strategies may also be simpler to replicate with automated tools at vastly lower costs.

Experts maintain that hedge funds will never cut their fees, that they offer a high skill service and will always be able to dictate price. I recall the days when commercial banks insisted that credit card businesses would never have to cut their charges (remember, once upon a time all cards carried an annual fee). Similarly, investment bankers argued with complete conviction that M&A fees would never be reduced. Both have come to pass. This shift to less complex strategies may set the stage for pushback on hedge fund fees.

From the Wall Street Journal:

The past decade has been the era of the hedge fund, as investors snapped them up for their track record of beating the market with often highly complex trades.

But now, as the credit crunch upends financial markets, that very complexity is coming back to bite some of them…

A pair of $2 billion funds run by AQR Capital Management Inc. are down about 15% this year. And yesterday Citigroup announced a bailout of an in-house hedge-fund group clobbered in part by bad bets on highly complex mortgage-related securities.

Last month alone, so-called “quantitative” hedge funds (which make investments based on sophisticated mathematical formulas) fell 6% as a group, according to data-tracker Hedge Fund Research Inc.

Other funds have hit the scrap heap. D.B. Zwirn & Co. and Sailfish LLC have both seen investors rush for the exits, forcing each firm to close big funds….

Total assets under management world-wide in funds like these now add up to $1.9 trillion, up from $490 billion in 2000.

The most-successful fund managers enjoy celebrity-billionaire status, even as regular investors struggle to figure out what they are up to.

This opacity, though, is now hurting hedge funds. Investors are pulling back, worried as they watch assorted financial institutions suffer from bad trading bets.

The recent exodus from the most sophisticated hedge-fund variants represents a flight to simplicity as investors snap up easier-to-understand assets instead. As a result, gold, silver, oil and other commodities are soaring. Even agricultural commodities, once the most boring part of the market, are on a tear. Soybeans and wheat are up more than 75% in the past year….

Not all hedge funds are taking it on the chin. A subset of funds that simply buy a portfolio of stocks while simultaneously betting on other stocks to fall — known as “long-short” funds — are currently in vogue.

Funds like these gained 10.5% last year and are down just 1.7% in 2008, soundly beating the market in both periods, according to fund-tracker Hedge Fund Research.

One of the hottest variants is one of the simplest: so-called 130/30 funds. These generally invest $130 in stocks they think will rise in price, then bet against $30 of stocks the fund considers overpriced. In a rough market, this strategy can be appealing because if the market does fall, the fund still stands to make at least some money on the bearish bets.

Investment funds using this style, including mutual funds, could manage as much as $1 trillion in three years, according to Merrill Lynch, up from almost nothing just two years ago and $75 billion today.

“Investors are shifting to simple strategies, where there is much greater pricing certainty,” says Henry Bregstein, an attorney at Katten Muchin Rosenman LLP, who is working with a client who is shuttering all of its funds that focus on hard-to-price strategies. “There’s also growing scrutiny of how all hedge funds value their positions.”

A big part of the problem facing the struggling hedge funds is that many count on investing heavy doses of borrowed money, or “leverage,” to amplify returns. Now, however, banks are either cutting their lending to hedge funds or making it more expensive to borrow. As borrowing gets tougher, the returns of heavily leveraged funds likely will be hurt.

Also hurting funds like these is the fact that investors are increasingly fretting about how they value their holdings. The risk is that funds may be overstating returns, or that they simply don’t know with certainty what their holdings may be worth, given the difficulties in the credit markets.

Lara Price, head of research for Octane, a firm that invests in hedge funds, says her firm has become more worried about whether the results of some debt-focused hedge funds reflect their true value, as more of their investments become difficult to trade.

This kind of nervousness has led investors to sell debt-related investments in recent weeks, representing a new blow for the markets. Because many areas of the credit markets remain virtually frozen, much of the selling is taking place in areas where investors can exit more easily — causing those areas of the debt markets to take particularly big hits.

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