Hedge Funds: Myths and Realities

Over the past decade, hedge funds have grown tremendously in terms of assets under management and also garnered a lot of media attention.

The $1.5 trillion hedge industry posted its worst ever performance in 2008. Almost a third of hedge funds will shut or merge after. The failure rate is going to go up, the closure rate is going up, and the merger rate is going up. The number of hedge funds more than tripled in the last decade to a record 10,233 at the end of June 2008. That number will likely tumble after funds dropped 18 percent in the year through November 2008, the worst year since HFR started its Fund Weighted Composite Index in 1990. The size of the industry in 2005 were around $ 1 trillion and in 2006 perhaps $1.5 trillion and in 2007 over $2 trillion.

However, the credit crunch has caused assets under management (AUM) to fall to $1.56 trillion as of November 2008 through a combination of trading losses and the withdrawal of assets from funds by investors. A record number of hedge funds were liquidated in the third quarter, as the business faces the worst crisis in its history.

Despite their growth and popularity, hedge funds still remain a mystery to many people who do not understand exactly what they are and how they work. Billionaire investor George Soros says hedge funds will be decimated by the global financial crisis. A new survey of financial advisers and institutional investors by Morningstar and Barron’s magazine finds widespread concern about the lack of liquidity in hedge funds, which more than half of respondents citing it as a reason to hesitate in picking hedge funds. Advisers and institutions also worry about the industry’s lack of transparency and fee structure.

Competition for investor assets in the hedge fund industry is fierce. According to Hennessee Group, nearly 70% of hedge fund assets now come from demanding institutional investors. In difficult market conditions, every basis point counts and fund managers need to be keenly aware of where money is made and lost and where it is being spent. Although it’s often overlooked, operational inefficiency may account for hundreds of thousands of dollars in unnecessary spending on technology, data and personnel. 

 Likewise the risk stemming from operations may expose the firm to thousands, if not millions of dollars in potential losses due to error-prone manual processes, unknown risk exposure to entities and counterparties and failed trades. The events during the global financial crisis have demonstrated the difference between firms that have strong operations and risk management practices, and those that do not. Further, institutional investors are demanding, not only in terms of performance but also in terms of operational soundness. They are more likely to invest their money with firms that can prove that they have a strong operational infrastructure.

Current market conditions and the investor and regulatory backlash is placing more importance on transparency, requiring fund managers to disclose more information about positions, risk management and operations to their investors. 

Historically pillars of safety for hedge fund managers, the reliability and the viability of service providers have recently come into question. Managers can no longer feel completely confident that their service providers offer absolute safety. The bankruptcy of Lehman Brothers revealed a new type of risk for hedge funds, who now have to worry about the viability and the balance sheet of their prime brokers. Those managers stuck with assets frozen in Lehman’s bankruptcy proceeding have learned this lesson the hard way.

Fortunately, the average hedge fund employs two to three prime brokers, either to access liquidity or asset classes or to protect their “intellectual property.” This practice made moving assets and switching prime brokers easier in the run-up to Bear Stearns’ and Lehman Brothers’ collapses.

N Janardhan Rao,  Senior Economist.