Exactly how much of the hedge fund industry is about to get chopped anyway?

Recent estimates about the imminent shrinkage of the hedge fund industry have varied widely. So we asked one expert to help us cut through the confusion.

The FT reports today that “US hedge funds suffer heavy withdrawals” with US hedge fund investors pulling about $43 billion of capital out of the industry. Some of this, posits one expert cited by the paper, is a result of investors preemptively pulling money out in anticipation of a ‘run” on the fund and the subsequent closure of redemption gates (see previous post). Another insider told the FT that the hedge fund industry would shrink by 50% over the “coming months” with half of the decrease (approx. $500 bn) coming from withdrawals and half coming from negative returns ($500 bn).

Fifty percent is the highest in a string of recent predictions about the size of the global hedge fund industry. In the same FT piece, JP Morgan estimated that less than 10% of funds will bleed from the industry. Robert Elliot of asset manager Bessemer Trust told Thomson News recently that the number of hedge fund would be cut in half by the end of next year. Credit Suisse expects the industry to shrink by a 33% in the next two years (UBP concurs). And the Tabb Group says the second half of 2008 will see a 15% reduction in the number of hedge funds.

Will the growth numbers vary widely, they all have a negative sign in front of them. To get a better idea of the extent and potential effect of hedge fund redemptions, we contacted one of the keenest observers of the hedge fund industry, Nicola Ralston, former chair of the UK’s CFA Society, recent contributor to AllAboutAlpha.com and co-founder of PiRho Consulting.

AAA: Will redemptions really be as bad as reported?

Ralston: There is no easy answer to this one. Clearly many individual funds are suffering from very large redemptions and will have to close as a consequence. One option for these funds is to split into two different funds, one of which is liquidated in as orderly fashion as possible while the other continues with some kind of lock-in and/or fee reduction.

More interesting is whether this will happen on a scale which shrinks the industry significantly in terms of both fund numbers and total assets. We would stick our neck out and say that perhaps 15-20% of the assets are at risk, rather than the figures of 30-50% which have been discussed in some of the press.

Institutional funds which have taken a considered decision to allocate to funds of hedge funds are unlikely to sell out in a knee-jerk reaction, although there may be some reallocation of strategies and products. On the other hand, some individual and family investors are reacting badly to seeing absolute losses, and are trying to liquidate for cash.

Many of the funds which will go under will be long only or long-biased emerging market funds that arguably had no real business being in a ‘hedge fund’ wrapper in the first place. Other funds at particular risk are those with strategies which are highly dependent on leverage, such as those in the convertible arbitrage sector. We also need to remember that this whole process is likely to be very drawn out as, in extremis, funds will impose whatever gates and lock-ins they can, not just to hold on to assets, but to ensure that assets don’t have to be disposed of at fire-sale prices.

It’s also important to distinguish between individual hedge funds and funds of hedge funds (FOHFs). There are a slew of articles forecasting the demise of the fund of funds industry, highlighting the liquidity mismatches that are squeezing FoHFs which have offered much better liquidity terms than their underlying holdings. There have also been several articles about the impact of their “double fee” in times of negative absolute returns. Indeed, it seems there is a large element of the industry that would like the FoHF model to fail, though it’s not clear what would replace it. Do all hedge fund investors have the time or expertise to undertake their own due diligence, for example? And, although we have long warned against FoHFs which take a cavalier attitude to severe liquidity mismatches, we should remember that almost all pooled products - and indeed the banking system itself - depend on investors not wanting to take their money out at the same time.

It does seem likely, though, that much of the money which is redeemed from FoHFs will not find its way back into hedge funds in the short term, and that this will be one of the contributing factors to the shrinking of the underlying hedge fund market. How much will the FoHF industry shrink? Probably the same amount as the shrinkage of underlying hedge funds, i.e. perhaps 15-20% of the industry, over and above the impact of market movements.

It’s interesting to compare performance of FOHFs with that of multi-strategy funds, which some have touted as a cheaper alternative to FOHFs. The net of fee performance for year to date (up to end September) for these categories is remarkably close, with the HFRI FoF Index down 11.0% and the multi-strategy index down 11.3%. The greater dispersion of multi-strategy performance and the greater exposure to manager risk, however, suggests to us that the majority of FoHFs are holding their own vs the multi-strategy funds. (All figures here are net of all fees).

We have always been very cautious about the idea the Multi Strategy funds are a good alternative to a diversified Fund of Hedge Funds, and see nothing in the current crisis to cause us to change that view.

AAA: Could redemptions really be large enough to impact markets materially?

Ralston: You probably saw the front page headline in the Financial Times yesterday ‘Hedge funds driving stock collapse‘, showing figures from Goldman Sachs which demonstrate that stocks which are heavily owned by hedge funds have performed markedly worse than those which are under-owned by hedge funds. There are a number of issues here…

• One feature of markets is that many investors tend to employ similar models (e.g. mean reversion or short term momentum models) which predispose them to be holders of the same investments even though they make their decisions entirely separately. As it is the marginal buyer or seller that drives the price, it is certainly possible for the prices of specific stocks to be particularly exposed to redemptions (or fear of redemptions) in the hedge fund market.
• In absolute terms the total value of all hedge funds is well under 10% of the value of the global equity market, so it is unlikely that even very large redemptions could be the main factor driving markets as a whole down.
• Some commentators almost seem disappointed that hedge funds do not appear to have been the catalyst for market meltdown, and are only too happy to find reasons to make hedge funds a scapegoat. We rarely find companies complaining when hedge fund interest results in buying pressure.

It is, however, interesting to note that while hedge funds have understandably come under pressure for failing (for the most part) to live up to the ‘absolute return’ tag, most commentators are relatively phlegmatic about equity performance despite global equities being down more than a quarter this year, on the grounds that equities are ‘supposed’ to be volatile. Interestingly, despite the awful absolute performance of the hedge fund indices, hedge funds have just had one of their best quarters relative to equities.

It is also worth considering the knock on impact of poor underlying performance and the imposition of gates and lock-ins on banks which offered capital guaranteed structured products on FoHFs. Potentially unable to realise cash from the underlying FoHF, the structuring bank is stuck with a very large economic exposure; this is likely to be a continuing issue for parts of the banking sector into 2009.