The Great Hedge Fund Meltdown of 2008

12/04/2008 12:00 pm EST

Focus: MARKETS

Nicholas Vardy

Editor, Bull Market Alert, The Alpha Investor Letter, and The Global Guru

Nicholas Vardy, editor of The Global Guru, says hedge funds have performed badly this fall, and many will go out of business.

The average hedge fund has lost between 15% and 20% this year—a disaster in an industry that promises positive returns in both good times and bad.

The industry's current travails are rivaled only by August 1998, when hedge funds lost 8.7% as Long-Term Capital Management imploded and sent the world to the brink of economic collapse.

Morgan Stanley expects the $1.7-trillion industry to shrink by close to one third before the current crisis is over. Dozens of hedge funds have already told investors they cannot get their money back right away as they try to stave off collapse. And this includes the highest and mightiest of hedge fund players.

Hedge funds are held to a different, tougher standard. While the average hedge fund is down by 20% or so, US global equity mutual funds fell by an average of 39% in the first ten months of the year and the Standard & Poor’s 500 Index was down 34%. But average figures about hedge funds mask a substantial divergence in performance. Some hedge funds are collapsing, while one in every 50 funds is up more than 30%. Many hedge funds promised such stellar performance. Few delivered.

In five of the last ten years, fewer than 15% of hedge funds lost money. Even in the industry's worst year in recent memory, 2002, two out of three hedge funds made money. This year, 70% of hedge funds had lost money through the end of September. For the next decade, every hedge fund presentation will include the question: "What did you do in September [and October] 2008?" The funds that were down these months will have trouble raising money. The ones that made a fortune are the new kings of the hedge fund hill.

[But] as a whole, hedge funds' average declines haven't been as steep as those of the major market indexes. And many funds are also held hostage to their stated investment strategies.

If you specialize in convertible bonds or foreign stock markets that have tanked, there is little you can do to avoid steep declines. About 35 of 70 hedge funds operating in Russia are expected to be wiped out by next year. Even China funds (remember the China Miracle?) are starting to shut down. Some hedge funds were crippled in September by the ban on short selling. Throw in redemptions from nervous clients, demand for more collateral from lenders, and accelerated asset sales from bankrupt financial institutions, and you have the makings of a perfect storm.

Here's the reality: Most hedge fund managers were hardly the Masters of the Universe of popular lore. As always, the greatest returns went to the top people at the top hedge funds. In that way, hedge funds are the dot.coms of their financial generation: A handful of funds become Amazon.com. Most go the way of pets.com. In that way, hedge funds are nothing new under the financial sun.

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