16 May, 2008 |

Hedge Funds Eye Shareholder Moves

Some hedge funds with heavy exposure to complicated, often illiquid securities likely are in for a rough ride in the next few months if investors take out their money.

Many funds’ returns have suffered. Heavy redemptions can deepen losses. The size of any exodus won’t be clear until Sept. 30, the deadline for paying August redemptions.

Some shareholders probably will bail if their funds are hurt by hard-to-price securities. That can make those securities less liquid. Many are linked to the subprime mortgage market.

The average hedge fund was up 0.37% in July, according to Hedgefund.net, which tracks almost 3,500 funds. That left them up 7.74% for the year. That beat the S&P 500 index, which returned 3.64%.

But funds whose strategies focused on the finance sector 37 funds fell an average of 3.88%. That was the worst of all sectors HFN tracks. It left that sector down 5.21% for the year.

Meanwhile, hedge funds that invested in the mortgage sector soared 13.07% on average in July.

Much of that gain was due to the few funds among a total of 15 in that sector that shorted mortgage securities, says Joel Schwab, managing director at HFN.

In May and June, mortgage hedge funds’ average returns were 0.25% and 3.64% respectively, and the range among funds was narrower.

August results won’t be reported until the month’s end at the earliest.

Hedge funds generally don’t let investors exit immediately, as mutual funds do. In the first six months of 2007, hedge fund assets rose 20.4%, to $2.59 trillion. Of that increase, $268 billion is new allocations.

Hedge fund assets have grown from $845 billion in 2003 to $2.6 trillion as of mid-2007. Mutual funds run $10 trillion.

Mortgage Meltdown

The subprime market meltdown didn’t make itself felt until the latter half of July. Several hedge funds had problems pricing instruments where the market all but dried up.

Three BNP Paribas’ funds that invested in subprime-related securities were frozen shareholders could not redeem assets because their net asset value couldn’t be calculated; there were no buyers or sellers.

Hedge funds often require shareholders to wait up to 90 days to take their money out.

Big redemptions can force hedge funds to sell ailing securities. That can push prices down more. It gets worse if a hedge fund has invested in illiquid securities.

Bear Stearns had those problems with two hedge funds. It froze redemptions. Goldman Sachs had to inject $2 billion into one of its funds.

Because of notice periods, some shareholders industrywide won’t be able to remove assets until Sept. 30 at the earliest. In the meantime, some hedge funds have to scramble to raise cash if the market doesn’t rally.

David Friedland, president of Magnum U.S. Investments which manages $500 million in hedge fund money says when hedge funds stop redemptions or can’t cover them, it often is because they can’t price a security and don’t want to risk underselling something.

“With stocks, it’s easy. There’s an exchange and you can get a price,” he said. “With debt securities, it’s different, you have to look around.”

People may prefer to invest in a hedge fund that is diversified and whose manager has been active since 1998 or earlier, Friedland says.

Those who remember Long Term Capital Management, which collapsed that year, are less likely to repeat that firm’s mistake: betting on single market sectors, expecting them to behave exactly as they had in the past.

Now, funds whose underlying instruments were linked to mortgage-backed securities will lose the most, Friedland says. They depended on the housing market staying strong.

An exodus of talent also will hurt, Friedland says.

As returns fall short of certain thresholds, many hedge funds collect zero or smaller fees. Managers and others won’t get bonuses. Many will leave. Some shareholders will follow favorite managers out.

Wider Wariness

“People got upset. Look at Bear Stearns,” said Charles Gradante, managing principal at the Hennessee Group.

Bear’s funds went under despite the firm selling some $4 billion of securities to cover redemptions.

Events like that make investors wonder whether they can always get their money out, Gradante said.

Hedge funds originally were designed to be relative return vehicles, smoothing out market volatility.

But that was before the proliferation of cheap money, complex derivatives and computer tools, which tempted more hedge investors to take risks. Many of those risks have now lost money, Gradante says.

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