While bubble watchers were obsessing over the housing market last summer, a soft hissing sound started emanating from the general direction of the capital markets. It didn't come from stocks, bonds, or even oil, all of which went on to close the year flat to positive.
The leak was in hedge funds, a $1.1 trillion industry that had doubled since 2000. By December the air was gushing out. Net money flows into hedge funds, which are investment pools available mainly to institutional and wealthy individual investors, were down 44% in the third quarter from a year earlier, according to industry statistics. And they slowed to almost nothing in the fourth quarter, observers say.
As the flows dried up, so did many hedge funds. Chicago's Hedge Fund Research Inc. reported in December that through Sept. 30, a record 484 funds, more than 6% of the total, had shut down in 2005. Figures for the fourth-quarter aren't available yet, but they're sure to be even worse, says Minneapolis hedge fund manager Andrew Redleaf. He describes the situation as a "recession for hedge funds," and says things are even bleaker than the data show because the numbers are based on unaudited results reported to industry groups. Some ne'er-do-well funds might overstate their results, while others might not report anything.
What went wrong for funds? In a word, performance. While indexes of hedge funds vary, Standard & Poor's (MHP ) measure, which tracks 42 funds across nine different investing styles, gained just 2.3% in 2005, less than the 4.9% total return for the plain-vanilla S&P 500-stock index. Some funds investing in emerging markets, health care, and the Asia Pacific region didn't even outperform simple exchange-traded funds, according to indexes compiled by the Hennessee Hedge Fund Advisory Group in Palm Beach, Fla.
On top of that, private equity funds are on a tear, with estimated inflows of a record $86 billion in 2005, up from $52 billion in 2004, according to the National Venture Capital Assn. "The really smart money is leery of getting into hedge funds now," says John S. Griswold, executive director of the Commonfund Institute, which educates institutions about investing. Private equity, along with energy and natural resources, is picking up the refugees.
The hedge fund boom began just about the time the bull market for stocks ended. Institutional investors, facing crippling losses in their equity portfolios, took note of the huge returns generated by funds that were making bearish bets on stocks and using leverage from options and other derivatives to juice their results further. With low barriers to entry, new hedge funds sprouted up everywhere, from the marbled corridors of Wall Street to the home offices of former day traders. The money pouring into them was staggering: $74 billion in 2004, compared with just $23 billion in 2000, according to Hedge Fund Research. Even retail shops like Charles Schwab Corp. (SCH ) and OppenheimerFunds Inc. jumped on board, offering hedge "fund-of-funds" investments, or shares of funds that invest in other hedge funds, to customers with as little as $25,000 in assets.
But the funds' high fees and rigid rules, coupled with the paltry returns, have been their undoing. The typical fund charges 1% to 2% of assets under management, plus 20% to 50% of any profits. Many funds also require that investors lock up their money for a long time, often a year or more, before selling. All of this was fine from 2000 to 2002, when hedge funds were beating the stock market handily. Now they're laggards -- pricey laggards that are hard to get out of.
Some investors have had enough. When the final numbers are tallied, inflows for 2005 could be as low as $40 billion, almost all of that money coming in the first half of the year, says Robert I. Schulman, chief executive of Tremont Capital Management Inc., a fund-of-funds manager.
Gold rushes tend not to pan out for latecomers. The endowments at Harvard and Yale Universities took big positions earlier in the decade that paid off famously. But many of the newer entrants haven't fared as well. Consider the University of Minnesota's $800 million endowment, which suffered investing losses between 1999 and 2002 as the Internet bubble popped. In 2003, then-new Chief Investment Officer Stuart Mason put 5% of assets into hedge funds. Six months later, he had 12% invested with 10 funds. Now, after mixed results, he plans to cut back on hedge funds and enter more promising areas such as timber, oil and gas, and distressed debt. "We're not huge fans of hedge funds," says Mason.
Many smaller investors have been turned off completely. Last summer an investment adviser suggested that the $77 million Scherman Foundation Inc., a nonprofit foundation in New York, try hedge funds, but Treasurer Michael Pratt didn't bite. "At this point, we're reluctant to get in," he says.
High-profile hedge fund blowups, including the debacle of Wood River, chronicled in these pages in October, haven't helped matters. The $450 million Bayou Group LLC turned out to be an outright fraud. Its July, 2005, closure was particularly unsettling because well-known industry consultants like the Hennessee Group had clients in the fund. Bayou principals Samuel Israel III and Daniel E. Marino pleaded guilty to fraud charges in September, and investors have filed lawsuits hoping to recover any money Bayou might have stashed away overseas. William Bloss, a lawyer for some of its investors, says his clients don't want anything to do with hedge funds anymore. "People are much less comfortable with this world," says Bloss.
The hedge fund industry isn't going away. Only 14 months ago, former Goldman, Sachs & Co. (GS ) partner Eric Mindich raised $3 billion for his Eton Park hedge fund, reportedly the biggest sum in 15 years. Plenty of Wall Street superstars will join him in the future. And when the stock market is clawed by the bears again, investors will be less concerned about the high fees charged by hedge funds and more enamored of their returns.
The recent slump in performance, says Kevin Quirk, a principal at Casey, Quirk & Acito LLC, an adviser to institutional investors, can be viewed as the result of hedge funds doing what they do best: taking less risk than other kinds of investments, and giving up some gains to protect against potential losses. "Hedge funds weren't very popular during the 20-year bull market," says Quirk. However, "when the idea of downside risk becomes more prominent again, people will be turning to hedge funds." In the meantime, however, many investors will be turning away.
By Aaron Pressman