Emerging-Markets Funds Tumble; ‘Short’ Managers Pull Off a 32% Gain

Hedge funds are supposed to thrive in rough markets.
Not in 2008. An historic decline in stocks, and troubles in almost every part of the bond market, dealt hedge funds their worst year on record. By the end of the year, investors were scrambling to get out, bringing an end to years of growth and creating uncertainty about the future of big parts of the business.

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Through November, the most recent data available, hedge funds globally lost 18% on average, according to Hedge Fund Research, a Chicago firm that tracks the industry. Although that’s better than the 38% loss on the Standard & Poor’s 500-stock index, including dividends, over the same period, it’s far from the gains most funds posted for more than a decade.

So-called long-short funds, the biggest category of hedge funds, were down 26% on average; their managers buy some shares while betting against others. Funds that invest in emerging markets dropped 30%.

Among the few that had gains, “short” managers, who bet on falling prices, were up 32%, by far the best performance. Global macro funds, which wager on trends in currencies, bonds and other markets, gained 5%.

Among the high-profile funds to suffer deep losses in 2008 were Citadel Investment Group, Farallon Capital Management and Highbridge Capital Management.

Some funds were forced to close, including London-based Peloton Partners LP, which crumbled over bad bets on U.S. mortgages, Ospraie Management’s biggest commodities fund and Citigroup Inc.’s Old Lane Partners, which invested in stocks, bonds and other securities.

Assets controlled by hedge funds tumbled to less than $1.5 trillion from nearly $2 trillion at the start of the year, according to Hedge Fund Research, and looked all but certain to continue falling into 2009. Hedge-fund assets are now back to their level in 2006.

Fund managers and their investors are trying to figure out what went wrong. One conclusion: Too many funds bought the same assets. As markets fell in September and October, and hedge funds came under pressure, many moved to sell these investments, sending prices even lower and causing osses for other funds that hadn’t yet sold.

“I have never seen this amount of cross holdings in my life among large hedge funds,” says Brad Balter, who runs Balter Capital Management, a Boston firm that helps individuals and institutions invest in hedge funds. “On the way up that worked well — they pushed the same stocks higher — but now it’s happening in reverse; they’re under pressure and bailing out of the same stocks.”

Stocks favored by hedge funds performed even worse than the overall market last year, according to data from Goldman Sachs. An index of 50 stocks “that matter most” to hedge funds lost nearly 45%, including dividends, compared with a loss of 38.5% on the S&P 500.

One looming problem for many hedge funds is the amount they still hold of hard-to-trade assets, such as loans, real-estate holdings and stakes in small, private companies. These illiquid investments at one time accounted for 20% of some fund portfolios, estimated to total about $400 billion. As financial markets have come under pressure, it has become much harder to get out of these investments, or even to value them accurately. That could hurt hedge funds as they try to attract new investors in 2009.

“Auditors do not, contrary to popular assumption, control a fund’s valuation policy; management does,” said Espen Robak, President of Pluris Valuation Advisors, a New York firm that gives advice on valuation issues. “An auditor auditing five different funds may sign off on five different valuations for a single investment.”

Another problem for the industry could be fallout from the December arrest of Bernard Madoff for an alleged $50 billion Ponzi scheme. While Mr. Madoff wasn’t a hedge-fund manager, his business of overseeing private accounts for wealthy individuals in tight-knit social circles from Palm Beach, Fla., to Long Island, as well as for charities and private-banking clients all over Europe, rattled trust in private-investment managers in general.

The scandal also tainted so-called funds of funds, the professional investment firms that raise money from clients and then select fund managers to trade that money. Several such firms channeled billions of dollars to Mr. Madoff through feeder funds, raising questions about how much due diligence those firms perform and whether, during a tumultuous year, clients’ investments were as diversified and safe as they might have been.

Something else likely to hang over the hedge-fund industry this year: an increasing number of funds with restrictions that make it difficult for investors to withdraw money when they want it.

All’s not lost for hedge funds, however. Survivors of 2008’s market tsunami likely will enjoy lucrative opportunities amid much less competition. As many as half the hedge funds that began 2008 could close, or be short of cash, as the new year unrolls. Those with cash on hand and a stable investor base will be able to take advantage of bargains in stocks and various debt markets.

A number of funds now are focusing on top-rated slices of mortgage-backed securities, for example. The area has been ignored since September but offers juicy yields and can hold up even if the housing market continues to slide, some bullish fund managers say.