The promise of hedge funds is that they have the freedom to move quickly in and out of different assets, and to bet prices will go down as well as up. That flexibility allows them to make money in any kind of market. In the turbulent conditions since 2007, however, few have delivered consistent profits.
Of 2,799 hedge funds studied by PerTrac Financial Solutions, a New York investment-software company, only 321 were agile enough to post gains every year since 2007 and in the first part of this year. Among the best performers: Perella Weinberg Partners Xerion, managed by Daniel J. Arbess (above), up a total of 95 percent from January 2007 through May; Waterstone, up 84 percent through June; and Banyan Capital, up 56 percent through June.
Notably absent from the consistent winners list: managers with top long-term returns, such as Steven A. Cohen, Louis M. Bacon, and Kenneth C. Griffin, who each posted their worst losses ever in 2008. Then there are the almost 3,300 hedge funds that have shut down since the start of 2007. As a group, hedge funds gained an average 10 percent for investors in 2007 and lost a record 19 percent in 2008 before rebounding 20 percent last year, according to Hedge Fund Research. The industry has lost 0.21 percent this year through June.
The winners made money through a combination of prescient investment calls, executing smaller trades with shorter time durations, which enabled them to get out of unprofitable positions sooner, and raising cash before markets slumped in 2008. Arbess, who manages $2.1 billion at Xerion, started shorting collateralized-debt obligations tied to subprime mortgages at the end of 2006. David Gerstenhaber of Argonaut Macro Partnership, profitable every year since its launch in 2000, bet in the middle of 2008 that European interest rates would fall and in September of that year shorted the euro.
What do these managers see ahead? In interviews and investor letters, they say they expect the U.S. and European economies to slow. Gerstenhaber, 49, plans to bet against industries that do poorly when the economy loses steam, such as materials, energy, and homebuilding. He and Arbess favor investments tied to emerging markets.
Shawn Bergerson, founder of Waterstone Capital Management, says he's betting against consumer-related stocks because he sees Americans curtailing spending and reducing debt amid high unemployment. "While I'm not expecting a major economic crisis or a disaster, the consumer is in a weak position," says Bergerson, 45, who oversees $1.17 billion from his office in Plymouth, Minn.
With the outlook so unclear, the $1.65 trillion hedge fund industry is taking less risk, using less debt, and making fewer trades, according to data from securities exchanges and brokers including Credit Suisse and JPMorgan Chase. Laurence Benedict, founder of $804 million Banyan Capital in Boca Raton, Fla., says he has reduced the size of his trades to about a third of what they usually are, and to the lowest since October 2008, because of uncertainty over the economy. "It's difficult to get conviction in this environment," says Benedict, 48, who holds trades for no longer than five days. "There will be more clarity by the third quarter following the release of economic indicators."
The bottom line: Even some hedge fund managers who have proven their ability to anticipate trends lack conviction about the economic outlook.