Absolute return – but only when the market goes up

Hedge fund managers have always claimed that they possess investment skills that can produce absolute returns no matter how the market weather. Investors in hedge funds obviously believed in this when they were willing to be charged several percentage points of the returns as management fees. It is now almost one year after the Dow Jones saw its peak around 14,000 and it has seen fallen by a scaring 40%. Oil is also down more than 50% from its peak and many other commodities have performed even worse. Against the backdrop of global fire-sales of asset, the typical hedge funds seemed to have done not too poorly: it has lost 20% in a year. But it definitely hasn’t lived up to its promise of generating absolute returns.

Why have hedge funds fared so badly? Most of the fund managers point their fingers at the ban on short-selling of financial stocks in recent weeks. Being able to sell short is necessary for hedge funds to hedge away the risks in their portfolios. So when the government abruptly banned short-selling, it prompted a simultaneous fire-sales of suddenly non-hedgeable risky assets. This hurts everybody and particularly hedge funds which employ the “convertible arbitrage” style, the type of hedge fund that lost most, 42%, a year to now. However, although the ban can partly explain why this September was the worst month for hedge funds since statistical data is available, it cannot explain why hedge funds have been constantly losing money in each month since the credit crunch broke out last summer.

The sudden disappearance of cheap money is one obvious cause. Skeptics have long argued that the huge returns of hedge funds come from nothing but leveraging on mediocre returns. When credit stopped flowing and interest rates went up to the roof, hedge funds’ interest costs surged and they had to liquidate some of their positions when re-financing became impossible.

Another plausible suspect, who naturally has not been blamed by fund managers, is their own client. When hedge fund first became popular in the 1990s, most of their assets under management came from super-rich individuals and banks. These are mainly loyal investors who do not ask their money back when times are bad. But as hedge funds become more and more known to the public, the picture is now totally different. Among the $2 trillion assets under management, almost 40% of them came from funds-of-hedge-funds which are the first to leave in the prospect that something bad may happen. The past month alone has seen a worrisome withdrawal of $20 billion from the industry. Most hedge funds employ strategies that require them to stay in the positions long enough to make profits. They are thus indeed hit hard by their own clients.

If the markets bounce back, capital may as well once again flow back to hedge funds. It is thus hard to say the current credit crisis would lead to a debacle of the whole industry. But certainly, as the promise of absolute returns is not realized, their clients would make the business much less profitable by demanding a reduction in performance fees.