Hedge Funds caught in a downward spiral

By Ray Nolte
CEO, Hedge Fund Management Group, Citi Alternative Investments

At the end of November, the HFRI Fund Weighted Composite Index, a broad industry benchmark, was down 18% for the year to date.

Until now, the worst year for the index had been 2002, when the return was -1.5%.

After many months, the funds are still caught in a downward spiral.

Market turmoil puts pressure on asset values. That, in turn, prompts investors to withdraw money, leading to more selling. Fund managers have been selling to raise cash and lower their risk exposure.

Lack of buyers

The damage has been worst among funds that trade in assets in which hedge funds are major buyers—high yield bonds, bank loans, leveraged loans and convertible securities.

Regardless of the fundamental value of these assets, technical factors are driving prices down.

By far, the worst-performing substrategy is convertible bond arbitrage. For the year to date, the HFRI Convertible Arbitrage Index is down 55.8%.

Long-short equity strategies declined 24.2% in the same period, according to the HFRX Equity Hedge Index. Still, this strategy has outperformed the Standard and Poor's 500 by nearly 15 percentage points.

Sole bright spot

The one bright spot is the Systematic Macro substrategy, which is up 16.8% for the year through November, based on the HFRI Systematic Macro Index.

These managers mainly use exchange-traded futures, on which margin rules are clear and the trading is transparent.

It is one segment of the hedge fund market not experiencing a liquidity crisis. In our view, more fund managers will start to use exchange-traded contracts in the future and step away from the OTC derivatives, especially in the market for credit default swaps.

Significant outflows

The industry is seeing its first significant outflows ever. Assets under management (AUM) were nearly $2 trillion during the second quarter of 2008 and are now in rapid decline.

We expect AUM to fall to $1 trillion in early 2009, with about half the loss coming from negative returns and half from redemptions. We would not be surprised to see an additional 10% decline in AUM by mid 2009.

To manage outflows, many funds built 'gates,' such as suspension of redemptions or issuance of special-purpose liquidating shares. In the past, such measures would have stigmatised a fund, but now they are almost the norm.

Institutional investors tend to be understanding while individuals are less accepting. Funds have been trying to mollify investors by lowering fees for those who agree to lock up their money for a longer period or for those who cancel redemptions.

However, some investors have been balking. With high-water marks so far away from current net asset values, many funds will be working for a long time with no performance fees. So, investors ask, why tie up money in return for a lower performance fee that may never be collected?