Hedge funds, the highflying darlings of the investment industry, have fallen to earth. These funds meant for sophisticated, rich investors just endured their worst year ever. The industry was down 18.5 percent as of November after an unprecedented six-month streak of losses. The amount of money the hedge funds had to invest, which peaked at almost $2 trillion last June, shrank by almost one-fifth by October, according to Chicago-based Hedge Fund Research. Some fund managers say the industry’s capital could shrink by as much as 75 percent.
Tens of billions of dollars are being pulled out of these secretive funds by nervous investors who seek to put their money in safer alternatives or need cash to meet other investment obligations. The wild swings in the stock market last year were due in part to hedge funds selling assets to meet redemption requests and to reduce leverage levels, analysts said.
Once predators on the margins of the market, hedge funds have grown into integral participants. Now they are under enormous stress. Congressional hearings have highlighted their potential to put the global financial system at risk through excessive use of debt to finance investments and through extensive links with banks and other large financial institutions…
"We’ve been living on borrowed time in that the industry has grown far more rapidly than we’ve been able to support with the existing legal, regulatory and investment infrastructure," said Andrew W. Lo, director of the Massachusetts Institute of Technology’s Laboratory for Financial Engineering. Though hedge funds are suffering, they have lost only about half as much value as stocks, which declined 38 percent last year, as measured by the Standard & Poor’s 500-stock index.
Most institutional investors seek a diverse portfolio of multiple hedge funds, said David Shukis, director of hedge fund research and consulting for Cambridge Associates, which advises college endowments and other institutional investors. "That combined with very good performance relative to equities going into this has led most investors to think that it’s still an attractive investment to have in their portfolio"…
Industry participants, including some fund managers, said that hedge funds have significantly reduced the amount of debt they have taken on to finance investments, with many now at more modest leverage levels of less than $2 of borrowed money for every $1 put up by investors. "Hedge funds were . . . an integral part of the bubble," said George Soros, one of the world’s wealthiest and most prominent hedge-fund managers, in testimony to Congress last fall. "But the bubble has now burst, and hedge funds will be decimated"…
When the bubble burst, these funds were among the first to experience losses. In late 2006 and early 2007, dozens of large funds began losing money or folding as mortgage defaults rose. In summer 2007, two Bear Stearns hedge funds, which had invested heavily in subprime mortgages, collapsed. That summer, Sowood Capital Management, a hedge fund in Boston, having lost half its capital following losses on bond market investments, was sold to Citadel Investment Group, which runs some of the world’s largest hedge funds. Citadel’s two largest hedge funds, with about $10 billion in capital, lost 50 percent of their value in 2008…
Last month, five hedge-fund managers who each made more than $1 billion a year were called before Congress to discuss the industry’s role in the crisis and the case for regulation. Four of the five said they thought that hedge funds could pose a systemic risk to the economy. "Any institution that has a pool of capital at its availability and uses reckless leverage indeed poses a potential systemic risk to the marketplace," said Philip A. Falcone, manager of Harbinger Capital Partners.
When pressed, the hedge-fund gurus agreed that they could probably live with some form of disclosure to a federal banking regulator, as long as the data are not shared with the public. Understandably, some fund managers see opportunity in the economic turmoil. "Markets are a train wreck," Singh told investors, "and there is substantial opportunity to profit handsomely."
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Good hedge funds really do know how to make money out of market inefficiencies.
I’ve referred to the Hedge Funds as "bottom feeders" in the past. The more I look into things, tI think I may be being too generous. The big catfish and grass carp in our lake clean up the mess on the bottom of our lake. They fit into a balanced ecology. Hedge Funds are more like piranhas who eat everything in sight, and would decimate the ecology of our lake in a few days. At the least, they add an unnecessary volitility to the marketplace with their extremes of leverage and sell-offs. More regularly, they skim value from the markets and concentrate it in the hands of already wealthy people. I have nothing against hard earned wealth, but this is something else. "Exploitation" is a word that comes to mind.
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When pressed, the hedge-fund gurus agreed that they could probably live with some form of disclosure to a federal banking regulator, as long as the data are not shared with the public.
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Markets are a train wreck and there is substantial opportunity to profit handsomely.
Hedge fund industry does require consolidation through tougher regulations by authorities, smarter due diligence from the investors and less use of leverage to reduce the cascading effect. This crisis is an opportunity for this industry to find a new and robust base and regain its fading charm.
Hedge fund regulation is likely to increase as Congress passes more laws with the intent of regulating the capital markets. Starting a hedge fund will become much more difficult in this new regulatory environment.