Commentary: Why Those Hedge Funds Are Getting Trimmed

By Gary Weiss

War, terrorism, disorder--for hedge fund managers, these should be grand times. Since these money managers for the wealthy can invest in just about anything, and can use borrowed money to leverage their bets, crises can turn them into overnight legends--or ruin their careers. Hedge funds performed spectacularly during the Gulf War and the European currency travails of 1993, but were humiliated by the emerging-markets crisis of 1998. So in the midst of national trauma, one might reasonably conclude that hedge funds would be princes or frogs. One would be wrong.

The results are in from September, and they are stunning in their lack of anything stunning. Hedge funds are doing well this year, but only by losing less than other investments. In contrast to the Standard & Poor's 500-stock index, which fell 8.1% in September, hedge funds fell 2%, according to Hennessee Group LLC, a consulting firm that specializes in hedge funds. The numbers from Hennessee and other trackers show hedge funds beating the indexes year to date, but failing to move into the plus column. Says Charles J. Gradante, Hennessee's chief executive officer: "Last year was a bad year and hedge funds were making money. This year was a bad year and hedge funds are not making money."

Clearly, these investment managers for the wealthy seem to have lost their raison d'être--to make money for their investors even when the rest of the world is suffering. And that is not a pipe dream by any means. In 2000, as the S&P fell 9.1%, hedge funds gained 7.8%, according to Hennessee.

Why is hedge fund performance so uninspiring? One reason is that the funds have learned well the lessons of Long-Term Capital Management, which collapsed after employing heavily leveraged currency and trading strategies in the summer of 1998. "Hedge funds this year have had a defensive posture," says Antoine Bernheim, publisher of the U.S. Offshore Funds Directory. And it shows.

This hesitancy is evident in the lackluster performance of high-rolling "macro" funds, which buy and sell currencies as well as stocks--and often use leverage to goose their returns. The biggest names of the hedge fund business in the past, such as George Soros, Michael Steinhardt, and Julian Robertson, all ran macro funds. Their counterparts today are down 5% this year, and declined 1% in September alone. While that's good news for the financial system--because it shows macro funds are taking more care in managing their risk--those are awful numbers compared with the past. In 1993, Soros' multibillion-dollar Quantum Fund gained 69%, much of it from betting on the decline in European currencies. None of the remaining large hedge funds is performing so handsomely. At the Pequot Capital Management hedge fund group, one of the largest, its flagship Pequot International hedge fund is flat so far this year, Bernheim notes.

SHORT OF PIZAZZ. The dearth of leverage is also evident from the performance of funds that sell stocks short, wagering on a decline in prices. Short-sellers were the leading fund group in September and in the year to date--but did not perform with a great deal of pizazz. In September, short-only hedge funds gained 11%, and they are up 16% so far this year. That's roughly in line with the decline in the market averages--meaning that the funds are not doing any better than an investor who simply sold an index product short.

To be sure, hedge fund investors are not suffering as badly as others. But considering the hefty fees they pay--usually 20% of profits, plus 1% of assets--they have a right to expect more than an absence of losses. But there's a reasonably good chance that this fallow period may linger for a while. Hedge funds are victims of their own past successes. A cottage industry just a decade ago, they are now a sizable part of the financial-services industry, with assets exceeding $400 billion. Gradante notes that there are just too many funds trying to exploit the same inefficiencies.

Until hedge fund managers overcome that problem, and their own timidity, their well-heeled investors are as likely to be as down in the dumps as everyone else.

Senior writer Weiss covers finance.

    Before it's here, it's on the Bloomberg Terminal.