Hedge funds could have an unprecedented level of cash pulled out by investors this quarter, according to insiders, just as they faced millions of pounds of losses from last week's shock regulation of short selling. It has been a tough year for the industry with high-profile funds blowing up, clients increasing redemptions, as well as public fury over short selling and increased threats of regulation.
One hedge fund expert pointed to The Hedge Fund Implode-O-Meter (HFI) as how he judges the state of the industry. The HFI was set up online in the wake of the credit crunch "to track as hedge funds learn the double-edged-sword nature of the often extreme leverage they use".
The group's "imploded funds" list has hit 51 companies since the sub-prime mortgage crisis in the United States kicked off a widespread downturn. That compares with its historical list, stretching back more than a decade to the end of 2006, of just 14, including the collapse of Long-Term Capital Management and Amaranth.
This year, big names including Peloton Capital Partners, Carlyle Capital Corporation and Dillon Read Capital Management are just some of the half century to collapse. "We think hedge funds have largely lost their way," HFI said. "Notably, most have abandoned capital-preservation for the goal of aggressive accumulation of capital gains, with the benefit of lax regulation and extreme leverage available to exploit."
It has 34 stocks on its "ailing/watch list" of those that have suffered significant value declines or temporarily halted redemptions. According to EuroHedge, a hedge fund data provider, 272 individual funds strategies were launched during the first six months of 2008, the lowest for nine years. In the same time, 243 funds have been liquidated, the highest in a six-month period.
Nouriel Roubini, the New York University economics professor, says worse is to come. He believes there will be an increase in client withdrawals and a shake-up of how funds are regulated.
The redemptions seem to have started in earnest, although currently the evidence is mainly anecdotal. One UK hedge fund manager confided that last week had the highest number of investors rushing to withdraw funds that he has known. The industry will know for sure whether it is a drip or a deluge when the data providers release their statistics for the third quarter, next month. One market analyst said: "I know even the good hedge funds have been suffering withdrawals recently. Investors are very nervous."
Performance numbers are also under pressure. Some have done well out of the market disturbance, but on average the performance numbers are at a low ebb. Andrew Baker, the deputy head of Aima, the hedge fund trade body, said: "The performance is undoubtedly soggy. There are not many strategies that stand out."
EuroHedge revealed that strategies that have done particularly badly this year include several run by Naissance Capital, once bankrolled by the Habsburg families, which are down a fifth and Pico Fund, which is down 32 per cent. At Endeavour Fund, set up by former Salomon Smith Barney traders, the second fund has fallen by 40 per cent, while its third fund is down 38.79 per cent in 2008. In the emerging markets, PharmaInvest Fund's investments in emerging markets are 38.16 per cent down.
Other funds have sought to lock in investors by halting redemptions. The latest example was RAB, with its flagship Special Situations Fund, as it was so desperate to prevent exits after a 22 per cent drop in performance that it offered vastly reduced fees in return for a lock-in period of three years.
One of the main problems experienced by hedge funds is the extent of leverage in the industry. The funds were able to take on huge amounts of debt, with little capital needed as security, to boost returns. One observer said some of the leveraged strategies were like "picking up pennies in front of a steamroller, and that only takes a turn in the market to cause severe problems".
Andrew Lodge, the managing director of fund of hedge funds Nedgroup Investments, said: "Some funds have gone in for huge leverage-driven strategies, which can be a problem. The appetite for leverage is less." He added that some could be affected by increased margin calls, and could face issues over their covenants.
At the same time, hedge funds, like the banks, have had to write down exposures to investments in risky instruments including collateralised debt obligations and asset backed securities, and also been exposed to the huge swings in the market.
Another issue is the regulators sniffing around. There have been wider calls for transparency and official controls of the industry, which has already been stung by the shock short-selling rules.
Mr Lodge said: "It's a myth to say hedge funds aren't regulated. There is a perception that they are running wild with no oversight, which isn't true. We would welcome some regulation, just as long as it doesn't strangle the industry."
On Friday, the FSA banned short selling in financial stocks, and forced hedge funds to disclose their positions. As the underlying shares rose as a result, the industry was looking at well over £1bn in paper losses on the day.
Stuart McLaren, financial services partner at Deloitte, said: "When the dust has settled, I expect the regulators to look at the role that hedge funds have played in the current issues. I expect there will be increased calls for regulation, but I doubt much will come from it."
Mr Baker said: "Some hedge funds are doing well. However, the number of professionals feeling good about life will be dwindling. The health indicators are generally negative, while costs are up and performance is down. Many are feeling battered and bruised and feeling worried about the future."
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