The first hedge fund was launched by Mr. Alfred Winslow Jones in 1949 – but is it all over after 60 years, when the last dime will be withdrawn next year?

The answer is of course no and the industry will continue to exist, but as the French finance minister Ms. Christine Largarde very wisely explained last week, is the financial world still deleveraging.  

Hedge funds have been a key driver behind leveraged gains in different asset classes. This makes the sector a natural force in the current “deleveraging period”. In the ongoing attempt to look into the crystal bowl I choose to check out on hedge funds as these people currently are key drivers in the market.

Depending on the sources, the number of hedge funds in early 2008 was between 8.000 and 10.000. 8.000 hedge funds that are covered by Hedge Fund Research (HFR) represented around USD 2 trillion of the USD 2,05 trillion that clients had placed in the sector. It can be no surprise that clients are withdrawing money as everybody cuts risk, but ironically are clients withdrawing capital from hedge funds, who have managed the crashing markets better than many others.

It is estimated that the USD 2,05 trillion have been reduced with USD 300 billion so far this year. As the notice period for withdrawing capital is between 3 and 12 month is it realistic to expect the outflow to continue for some quarters yet. One guess in the market, is that the number of hedge funds and capital under management will be reduced with 25% i. e. USD 500 billion. It’s hard to judge what leverage the different hedge funds have, but surely the deleverage in the market will continue. Again it is difficult to say what assets will be sold as some hedge funds runs large short positions as well, but overall hedge funds will still be net sellers of assets. The short positions will cause strange sudden moves upwards. If this estimate holds, then we are more than half way through (very important). It’s huge sums, but if you look into history it just brings the industry back to the 2005 level. The risk is that investors are forced to reduce further, meaning we are not even half through in the asset reduction.

The year-to-date result for all hedge funds (HFR index) is -17,6%. A result many investors would dream about when they look at their own equity portfolios today. The results of course varies from -50% in minor sectors to a few positive results, but the very important Long/Short equity hedge funds have delivered an impressive +0,8% year-to-date result (HFRX sub index) – so why are investors fleeing?

During these serious credit crunch times it would be easy to say that hedge funds can’t find the financing, making it uninteresting for investors to be in the game. In the reports and the comments I have seen, it seems that hedge funds can continue to fund their leveraged business – i. e. not the primary reason.

Some institutional clients needs to change their risk allocation during turbulent times, this explains a part, but only some. There are 2 other good explanations.  If private investors need to free up capital, they have the strange habit of closing out liquid investments where they haven’t lost money. Everybody needs free capital these days, so they cut hedge fund investments where the capital still might be intact. Another explanation is that hedge funds have been famous for moving money around very fast – the hot money. Their investors liked them for that, but now the hedge funds suffer from this habit, as it’s not “hot” for private investors to place money at hedge funds any more (and the hot money probably went up in the air somewhere else).

My conclusion is that the hedge fund industry will continue, but investors will withdraw capital further. The question is if the industry scales back to the 2004 or the 2006 level (-50% or -25% of the capital under management as of early 2008). I think closer to 2004 than 2006, but I also think that the industry already have reduced risk for more than equal to the USD 300 billion risk capital, mentioned by some industry sources. All in all is the risk reduction probably half way through or even a bit more.

Where will the private hot money go? Most of them are gone the same way as hot air – up and away. Ms. Largarde is right, the world is deleveraging…..looks to go on for another 6 months time. In particular CHF and partly JPY will gain and hedge funds must be net sellers of stocks.   

Best regards

Peter

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