Hedge Funds: The Next Shoe to Drop

by: Felix Salmon September 30, 2008    
Felix Salmon

Felix Salmon

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You think things are bad now? Just you wait: the chart above gives you a very good indication of what Christine Williamson calls the "bloodbath ahead" in the hedge-fund industry.

No one wants to be invested in an underperforming hedge fund right now -- and half of the hedge funds in America are underperforming. What happens when investors decide to take their money out tomorrow, as they're generally allowed to do on the first day of any quarter?

Sources said they expect the body count to total as many as 2,000 hedge funds and 500 hedge funds of funds between now and the end of March...

Most hedge funds operate on an end-of-quarter deadline for requests from clients to have their money returned. If experts' predictions of very large collective redemptions come true, managers will have to liquidate their holdings en masse, pushing down prices and forcing many smaller hedge funds or those with poor returns out of business. The wave of closures could span six months, likely beginning in earnest in November and December at the end of the typical 45- or 65-day waiting period when fund managers have to return investor cash.

What you see in the chart is the enormous range of returns between the best-performing and worst-performing hedge funds -- a range which has never been wider. Ironically, it's the result of the fact that hedge-fund returns during the Great Moderation of 2002-7 were very closely grouped together -- something which prompted funds to take on extra leverage to boost their returns. In turn, all that extra leverage helps explain why the top 10% of funds is up more than 50% over the past 12 months, while the bottom 50% is down more than 25%.

It's not just redemptions which underperforming hedge funds have to worry about, either: it's also employees, who are going to have a much smaller performance-related bonus pot to split between amongst them this year.

These problems are propping up elsewhere on the buy-side, too: according to the WSJ, the reason that Lehman Brothers (LEH) ended up selling Neuberger Berman for $2.15 billion rather than somewhere between $7 billion and $13 billion was that

the deal was held up in recent weeks due in part to protracted contract negotiations with the Neuberger money managers. People involved the discussions have described the process of persuading them to sign on to the deal as something akin to "herding cats."

Could it be that all these fund managers were simply paid far too much money over the past few years? After all, they can't all find well-remunerated work elsewhere. But for many of them, that probably doesn't matter:They can live quite comfortably off what they've earned already, and if they feel like making more they can just start investing their own funds, without having to worry about office politics or the trader sitting next to them blowing up the entire firm.

In any event, the hedge-fund shakeout over the coming months could be brutal, and have nasty systemic consequences if hundreds or thousands of hedge funds are all trying to unwind their positions at the same time. In the worst-case scenario, a fund which wrote a lot of credit protection could go bust, leaving its investors with nothing and its counterparties with very little. If the counterparty dominoes then started to fall, the financial system could end up in much worse shape than anything we've seen so far.

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This article has 14 comments:

  •  
    Sep 30 05:46 PM
    No worries. I'm sure we'll just print up some more dollars and bail them out too.
    Reply | Link to Comment
  •  
    Sep 30 09:16 PM
    Very good analysis that must be remembered when analysing market dynamics in the coming months. Whereas hedge funds used to boost the markets during the boom 2003-7, they are likely to drag markets lower in the months and quarters ahead until the system stabilizes.
    Reply | Link to Comment
  •  
    Oct 01 05:14 AM
    Hm, I think, they are a wildcard and hinestly, much odf the selling in bonds and stocks has already been due to hedge fund liquidation. After all, credit facilities for them have been shut down or gotten very very expensive long ago. heck, it could even give a boost to certain stocks. Just look at the very high open short interest, much of which is due to hedge funds ( and not just long-short equity funds).
    In any case, the most important measure of them all is to get a central clearing house for the CDS market exactly to prevent a domino-effect.
    And funny thing: there has been so much credit protection been written on certain companies that they vastly exceed the bonds that were insured - and deliverable, for that matter. Now, as I understand, when you bought a CDS, say on GM, then you go to your counterparty and deliver the bonmd which it is written on(!) and in exchange you get par value (or whatever the CDS-terms specify)
    Now, I wonder from where will all the CDS-buyers take the bonds for delivery, if the notional amount exceeds the actual bonds outstanding by many many times? That could be really funny to watch. Or maybe not.
    Reply | Link to Comment
  •  
    Oct 01 08:21 AM
    Methinks the Hedge Funds Derivatives are the primary cause of todays cash panic.
    Reply | Link to Comment
  •  
    Oct 01 08:45 AM
    people vote against this bailout or you will be reduced to poverty not seen since the great depression, this was on kudlow tonite: 9/30/08

    "Paulson and Bush threatened to veto the legislation if there was an explicit prohibition of transfers from foreign banks to an American subsidiary."

    THE ASSETS DO NOT EVEN HAVE TO BE AMERICAN MORTGAGE ASSETS - THEY CAN BE AN OFFICE TOWER IN SHANGHAI!

    YOU ARE GOING TO GET FLEECED FOR HUNDREDS OF BILLIONS OF DOLLARS IF THIS BILL PASSES - THAT MONEY IS GOING TO GO IMMEDIATELY OUT OF THE COUNTRY!




    SEC. 112. COORDINATION WITH FOREIGN AUTHORITIES AND CENTRAL BANKS.

    The Secretary shall coordinate, as appropriate, with foreign financial authorities and central banks to work toward the establishment of similar programs by such authorities and central banks. To the extent that such foreign financial authorities or banks hold troubled assets as a result of extending financing to financial institutions that have failed or defaulted on such financing, such troubled assets qualify for purchase under section 101.


    votenobailout.org/
    Reply | Link to Comment
  •  
    Oct 01 09:21 AM
    the new motto to be printed on our monopoly money-TOO BIG TO FAIL<TOO MANY TO JAIL.> i keep asking,what good are hedge funds?no answer yet.
    Reply | Link to Comment
  •  
    Oct 01 09:34 AM
    Paulson should return to Wall Street and draw his paycheck from those he is working for. Bernanke should return to academia and study Depressions, instead of causing one in America. Bush needs to disappear to his W. Texas hangout and count tumble weeds. He and Carter did more damage to America than any Presidents in history!
    One Republicans Humble opinion
    Reply | Link to Comment
  •  
    Oct 01 10:11 AM
    Self Preservation!!

    On Monday I walked into a bank in Kansas to withdraw a large sum of money. I was taken into a managers office who told me that they could only give me one tenth of what I asked for. They told me I could order another 4/10ths but they couldn't tell me when it would be available due to "bank security". They are supposed to be calling me on my cell phone when the money is available. It is now 9:00am on Wed and I haven't heard from the bank...
    I am a little concerned... to say the least... Has anybody else tried to take a large sum of cash out from their bank? Not a check... cash???
    Reply | Link to Comment
  •  
    Oct 01 11:12 AM
    Historians will be writing about this infamous time in our country for centuries. The worst president, the worst congress, the worst Treasury and Fed heads, the most crooks on Wall Street due to gov't bank deregulation, and the biggest consequences for Main Street since 1929.

    The incredible thing in all of this is that the above mentioned people are very rich and will not be impacted at all by their own despicable actions that has pushed America to the brink. And, we let them do it.

    America, what a country. And justice for all.
    Reply | Link to Comment
  •  
    Oct 01 11:12 AM
    Not sympathetic with the plight of any investment gimmick sold to those looking to profit. Good riddence to all of them. The world will be better off without them..........
    Reply | Link to Comment
  •  
    Oct 01 11:27 AM
    In the next few years, Americans might actually be called on to think about economics, in the old definition of the term, political economy.

    Adam Smith was, after all, a philosopher.

    Since we are a republic and not a direct democracy, this will have to take place through our representatives in Congress.

    (No, that wasn't a joke.)
    Reply | Link to Comment
  •  
    Oct 01 01:17 PM
    Frankly, who should care if all the hedge funds go out of business and all the arrogant fat cats with the huge bonuses and overinflated egos actually have to get a regular job. What we should worry about, really, is that these unregulated funds have had the audacity to sell CDO's, make swaps and do huge trades with complex instruments on huge leverage and have done this in secret with no oversignt. When these deeds and misdeeds are uncovered, they may have undercut any good the bailout plans and the government interventions around the globe, may be doing. Just the fact that no one knows what has been done, what has been committed to, etc. is a disgrace and the oversight officials in all the governments around the world should have egg on their faces. Regardless, who do you think will be the real losers?
    On another point, these same fat cats have raised separately, huge sums of money to invest in the toxic assets which the government will sell off, after they do the bail out deal. Does anyone know who controls these assets and how much is involved? Again, no oversignt. The individuals who have been responsible for the debacle will reap the benefits once again. All in the name of free enterprise. Hopefully the new President, whoever he is, will at least try to understand the problem and make some corrections. The fools who have run the government for the past 8 years do not seem to have a clue (and/or maybe they have actually benefitted mightily).
    Reply | Link to Comment
  •  
    Oct 01 04:32 PM
    the american sheeples should face it.they have been had.the younger ones can recover over time.the elderly are screwed.
    Reply | Link to Comment
  •  
    Oct 01 11:55 PM
    notsosmart:

    The only thing the sheeple have to face is the grass under their mauls.

    And don't worry about the elderly. They've got most of the money. It's the young who will get screwed and they'll be happy to be getting laid.

    Life goes on.
    Reply | Link to Comment
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