Secrets Of Success: Hedge funds prevail despite losses

You can be sure that an asset class has arrived in the mainstream when it gets to feature in the agenda for a meeting of the G8 world leaders. So this weekend, although most media attention has centred on poverty and Africa, it is safe to say that any lingering doubts that hedge funds are here to stay have finally been extinguished, as long predicted in this space.

In the past month, no less a collection of luminaries than the German Chancellor Gerhard Schröder, the chairman of the Federal Reserve Alan Greenspan and the head of the European Central Bank Jean-Claude Trichet have all chimed in on the subject. The main debate is whether or not the rapid growth in hedge funds has contributed to an increase in risk in the financial system.

The Bank for International Settlements has also chipped in its twopenny worth in its annual report. While it may not be quite the publicity that hedge funds need, being fingered as a potential source of a breakdown in the global financial system underlines how far this new medium of investing has come in the last five years. There is no question that they are here to stay.

It is ironic, but not at all surprising, that the growing acceptance of hedge funds by institutions and individuals alike has coincided with a downturn in their overall levels of performance. A number of funds, as I predicted a few weeks ago, have thrown in the towel, either because of unacceptable levels of losses or simply a failure to produce adequate results. Both trends are signs that the market is maturing after a period of rapid growth: some analysts even suggest that the inflow of money into hedge funds may even have gone into reverse for the first time this year.

This is what Greenspan had to say on the subject of hedge fund performance last month. "Most of the low-hanging fruit of readily available profits has already been picked up by the managers of the massive influx of hedge fund capital, leaving as a by-product much more efficient markets and normal returns. These entities have been able to raise significant resources from investors who are apparently seeking above average risk-adjusted returns, which of course can only be achieved by a minority of investors."

That is certainly part of the story, though as the market analyst Peter Bernstein notes in a recent economics and strategy newsletter, it may not be the growth in the number of hedge funds that is leading to more efficient markets (and therefore lower returns) in their specialist areas. It might be (and he thinks is) the other way round: it is the general efficiency of markets that is helping to produce the disappointing returns that many funds have been experiencing to produce.

As always with discussion of hedge fund activity, it is dangerous to generalise, as the specific market niches in which many funds operate are so very different. In some cases, the problem facing hedge funds may be simply that the opportunity they have been exploiting (say a certain emerging market's debt) has simply disappeared. For other funds looking to exploit short-term trading strategies, such as convertible arbitrage, the opportunity seems to have been temporarily competed away. In other areas, many hedge funds continue to produce good performance figures.

What is certain is that investors are starting to wise up to the fact that putting money into hedge funds is not the one-way bet it may have seemed.

The general marketing drive behind the growth in their business has tended to emphasise the apparent low-risk nature of hedge funds, with their stated objective of pursuing absolute (rather than relative) returns, and low correlations with other asset classes. Quite a few hedge funds are so low-risk that they barely seem to be alive at times.

Yet other funds, including some of the bigger names that have run into difficulties this year, have made some surprisingly high monthly losses this year, emphasising the inherent riskiness of their strategies, often the result of using leverage to inflate returns. When you are paying such handsome fees for performance, such big losses are doubly unwelcome, which is one reason why hedge funds' assets tend to dry up very quickly when they have a poor period. The money drains away like sand, implying that many hedge fund investors, whatever they might say, are actually looking for short term rather than long term returns.

Few names can consider themselves exempt from investor fickleness. GLG Partners, one of the biggest in Europe, founded 10 years ago by three partners from Lehman Brothers, is said to have suffered large withdrawals from two of its 14 funds. Like a number of other funds, and the trading desks of the large investment banks, the funds in question seem to have got themselves the wrong side of some leveraged trades in credit derivatives, with costly results. The same goes for the Bailey Coates Cromwell Fund and Aman Capital, which have both closed down after suffering losses and a consequent large wave of investor selling.

In both these cases, the managers involved had good track records and lots of relevant experience. This only underlines a painful fact of market life. While it is true that many of the most talented investment managers are leaving conventional fund management houses in order to set up hedge funds, it does not follow that all hedge funds will perform as a result.

That is because talent alone is not enough for success in any field of investment. The reason good fund managers like hedge funds is that it gives them an opportunity to make a lot of money very quickly and to do what they do best with the minimum of constraints. But even the best cannot escape the harsh truth that the markets routinely make fools of even the best and the brightest talents. While hedge funds are here to stay, it doesn't change that fact.