By Matthew Lynn –
We always knew the financial markets were subject to violent, often neurotic, mood swings. Even so, the speed at which hedge funds have turned from the stars to the dogs of the investment universe has been startling.
A few months ago, everybody was starting a hedge fund. Now, it seems, nobody wants to go near them. The quoted funds have come up with disappointing results. Hedge-fund indexes are dropping. In London, analysts say the bubble is popping.
Yet, as Mark Twain may have put it, the death of the hedge fund is much exaggerated.
The rise in importance of hedge funds — which use high-risk investment techniques such as borrowing money and selling short in an effort to outperform traditional funds — is a response to a change in demand from investors. That isn’t about to change and hedge funds aren’t about to disappear.
Still, without question, the past three months have been the toughest for the hedge-fund industry since the collapse of Long- Term Capital Management LP in 1998.
Man Group Plc, the world’s largest hedge-fund group and one of only two in its industry to be publicly traded in the U.K., has come under pressure as its flagship funds suffered a dip in performance. Ten of its 11 biggest funds declined in the first half of 2004, according to Bloomberg data. Investors have taken fright, aware that if performance sags, Man Group will collect lower fees, and may struggle to attract fresh money. The shares have fallen to about 13 pounds from more than 18 pounds in April.
RAB Capital Plc, which was listed on the London market earlier this year and has $1.5 billion in assets under management, has also been having a tough time. Although it reported a surge in first-half net income, the company said the second quarter was “disappointing” as its funds struggled. The shares now trade at about 27 pence, compared with a peak of 63 pence soon after its initial public offering.
Away from the quoted sector, there are other worrying signals. New York-based Andor Capital Management LLC, the eighth- biggest hedge fund at the end of 2003, lost almost half its assets last month, people familiar with the fund said, after a weak performance at some of its funds and investor withdrawals worth $1.5 billion. The company declined to comment.
The entire industry struggled in the second quarter of this year, recording its first quarterly decline since the third quarter of 2002, according to Hedge Fund Research Inc. “Less than ideal trading conditions for hedge funds were characterized by sudden reversals in market trends,” said Joshua Rosenberg, the president of the Chicago-based research company, in a statement accompanying the figures.
These results have prompted some people to wonder if the hedge-fund bubble is finally bursting. Dresdner Kleinwort Wasserstein this month published a research note arguing that hedge funds are an investment bubble that has probably now reached its peak — and may even have passed it. “To us, it looks like the hedge fund bubble is in its euphoric stage,” said Dresdner analyst James Montier in an e-mailed response to questions, adding that the bubble may pop soon.
Has the hedge-fund fad passed?
Well, not so fast. True, there has been a difficult quarter. And so many hedge funds have been started that at least a few are sure to run into trouble. That doesn’t mean the bubble has burst.
Hedge funds have had explosive growth for three reasons.
First, investors are fleeing the suffocating blanket of regulation in which most mainstream investments are now wrapped. Most hedge funds are based offshore, and loosely regulated. Many investors are happy to accept less regulation for higher returns.
Second, the hedge funds target absolute returns — they don’t just try to outperform an index. That’s more in tune with what most investors want. Few of us aim to do just slightly better than an index. We want our money to be worth a bit more this year than last. The hedge funds try to deliver that.
Third, the hedge funds have expanded the investment universe significantly. They invest in a broader range of assets, such as currencies and commodities, using more instruments, such as derivatives. That gives investors the opportunity to diversify their holdings.
Those are three solid reasons why a few slow months won’t frighten investors for long.
Hedge funds have attracted some of the best brains in the financial universe (as well as a few charlatans and fools). Tim Price, senior investment strategist at Ansbacher & Co. in London, said all the new funds may well reduce returns in the short term. “But when was the last time you heard of all the furious intellectual capital being devoted to `traditional’ investing?” he said in an e-mailed response to questions.
Calling the Peak
Quite so. In reality, hedge funds are a long-term growth industry. Calling the peak now is like saying the auto industry had reached its peak in 1910, or the personal-computer business had nowhere else to go in 1980.
According to Morgan Stanley research, hedge funds still only control 1.5 percent of global invested assets. That’s a tiny proportion of the world’s money. The funds are going to be around for a lot longer — and they have a lot more growth left in them.
Contact the writer of this column: Matthew Lynn in London