Hedge funds: Next in line?

Fate of these funds does matter - not just to the rich, but to all investors

NO ONE knows where the next domino will fall amid this financial crisis but the US$2 trillion (S$2.9 trillion) hedge fund industry looks as good a candidate as any.
There has been an exodus of money from the funds in recent weeks, raising fears the industry may collapse.

But no one is talking about a US$700 billion bailout for these guys. No one will be shedding tears if a run on even the biggest 'hedgie' kicks in.

Yet the unthinkable prospect of a bailout could still happen given that some hedge funds are so large, so interlocked with the financial system, that they cannot be allowed to fail.

It has become painfully clear that in this complex global economy, the fate of hedge funds matters, not just to the rich who can afford them, but to all investors.

These funds claim to deliver absolute returns in both rising and falling markets, using strategies like leverage unavailable to other investments. Pension funds, foundations and sovereign wealth funds, including those from Abu Dhabi and Singapore, have invested in hedgies.

But returns this year have averaged a negative 10 per cent, according to Hedge Fund Research. Doomsayers portend the demise of one-third or so of the 12,000 hedge funds worldwide as jittery investors demand their money back.

Hedge funds are facing investor redemptions of between 10 per cent and half of their funds, forcing them to dump shares, bonds and other securities to raise the cash, said the Financial Times.

Hedge funds account for an estimated 30 per cent of equity and bond trades in the US and beyond, according to consultancy Oxford Analytica. So the knock-on effect of their forced selling on financial markets may well be a knock-out.

Asia-focused hedge funds have fared worse than the rest. Many are based in Hong Kong and Singapore, which have been vying to be Asia's hedge fund hub.

Yet the talk of Armageddon has a familiar ring to industry veterans. Hedge funds have gone under then bounced back before. Recall the crises of 1968, 1972, 1986, 1987, 1998 and 2002, says fund manager Ramiz Hasan of Samena Capital.

In Singapore, where the industry of over 170 hedge funds is still relatively young, many hedgies earned their battle scars during the collapse of Long-Term Capital Management (LTCM) in 1998, which sparked a liquidity crisis. The implosion of Amaranth Investors in 2002 tested their mettle as well.

The resilient industry resurfaced each time. But things seem worse now, given the scale of the current financial crisis.

The shock bankruptcy of Lehman Brothers choked many hedge funds of their much-needed assets, which they had pledged to the prime broker in return for loans to make investment bets.

Then there are Collateral Fund Obligations (CFOs) - the hedge fund equivalent of the toxic assets that forced banks to write-down billions. As ratings agencies start downgrading CFOs, several hedge funds may find the value of these assets disappearing.

The ban on short-selling is also tying the hands of hedge funds, which rely on this tool to make big gains by exploiting market inefficiencies.

And then came Oct 1 - or D-Day as Reuters called it - the final date for clients to put in redemption requests to get their money back by the year-end.

Asia-focused funds arguably have the most to fear from redemptions, given that the HFRI Asia ex-Japan Index fell over 20 per cent for the eight months to the end of August - the worst performing index among those tracked by HFRI.

The freefall in overvalued China and India stocks this year was partly to blame for the poor performance.

But about 46 per cent of Asia-Pacific hedge funds are also largely focused on long/short equity strategies that made them more vulnerable to losses when Asian equity markets fell, said Mr Hasan.

Asia-Pacific hedge funds hold US$168 billion in assets - 5 per cent less than a year ago. Poor performance and investor exits caused 70 of the roughly 1,200 hedge funds in Asia to go belly-up in the year to August, up from 59 a year ago, said consultancy Eurekahedge.

Of the 70 shuttered funds, 10 were in Singapore. Interestingly, the failed funds averaged under US$50 million in size.

The minimum size for hedge funds to survive may well be US$100 million in the tough new world of turbulent markets and more regulations, which drive up compliance costs, said Mr Hasan.

One estimate is that funds should be US$500 million or more if they are to enjoy reasonable returns and cover management fees. Just 10 per cent of Asia-Pacific funds are of this size.

The current turmoil will likely lead to consolidation of the industry, with experts predicting the death of more than 1,100 funds this year. The ones that remain are likely to be mega funds with stronger balance sheets and the best fund managers. But the scale of the shake-up is reflected in the fact that even the largest players with over US$30 billion each in assets are wobbling.

Examples include Farallon Capital Management, which fell by 8 per cent; Renaissance Technologies, with a nearly 15 per cent decline; and Goldman Sachs Asset Management, with an 8 per cent drop, according to Absolute Return magazine.

If these funds were to collapse, would they warrant a bailout because they are so large and likely to have an impact on the financial system?

There is already a precedent of a hedge fund bailout - in 1998, LTCM was rescued by the private sector in a deal orchestrated by the New York Federal Exchange. And today's mega funds are far larger than LTCM.

But a bailout is not a likely scenario. The industry will pull through on its own, as it has done many times in the past.

Still, the current financial turmoil has prompted hedge fund managers to relook their business models and make changes. Those left standing when the dust settles on the corpses of the cowboy hedgies will have much bigger financial and risk management muscle, and be backed by a more diversified investor base.

After all, in an industry that thrives on the survival of the fittest, hedge funds live by the mantra that whatever does not kill you only makes you stronger.