Hedge funds face image problem

If you mentioned the names Bear Stearns, Ospraie and Sowood to investors a year ago, their eyes would likely have lit up with dollar signs flashing across their retinas. These hedge funds were powerful players, making big returns and helping investors get rich. But utter a word about these companies to investors today and you’ll hear nothing but expletives.

Like every financial sector, industry and fund-type, hedge funds are hurting. On Friday, the $16 billion Citadel Investment Group was asked by a number of major banks to put up more cash to cover major investment losses, while British-based Man Group saw its share price plummet after it announced that it’s lost $6.6 billion since September.

But, while other industries are seeing layoffs and closures, it’s the hedge fund world that is bearing the brunt of investors blame for the market sell-off. Whether the criticism is warranted or not, the fact is the industry is changing and needs a public relations makeover fast.

Jeffery Shaul, president and CEO of Toronto’s Robson Capital Management says a lot of the hedge fund industry’s problems stem from companies who shouldn’t be called hedge funds at all.

“One of the big difficulties in all of this is the definition of a hedge fund,” he says. “They originated in the 1940s, where there was a portfolio of equities that was hedged by a short position either on the overall index or specific short positions. Somehow between there and today we’re in a situation where almost anything that is a not a long only mutual fund is called a hedge fund.”

Shaul explains that the funds that have seen 30% and 40% return are companies “that don’t really have any hedging involved. They’ve become one directional, they’ve been leveraged, many in Canada only focus on one sector — the natural resource sector where returns were quite high.”

The funds that are more stable are those that take risk into account. “Unless you have a risk management system in place to deal with market downturns you’re going to get hurt badly when the market turns,” Shaul explains. “That’s where the ones you see today are going under, or are going to shut down. They don’t have a robust risk management system in place.”

Phil Schmitt, chairman of Canada’s Alternative Investment Management Association, agrees that the definition of hedge fund has veered off the rails and that many of these operations promising high-returns should be called, simply, alternative investments.

“In the old days the ability to short and use leverage, that defined a hedge fund,” he explains. “Those techniques were generally used for absolute return strategies. But that’s extended to full range of options, such as 130/30. That loosely would be defined as a hedge fund, but, in fact, it was never intended to be one.”

He goes on to say that it’s unfortunate many people lump these lightly hedged over-achieving funds in with a more pure hedge fund, and that he’d “love for people to understand the differentiation among fund types so people are aware that not everyone is offering the same thing.”

At Man Investments Canada, CEO Toreigh Stuart isn’t panicking. Although his company is a subsidiary of Britain’s Man Group, the company’s Canadian operations is growing – they’re opening an office in Calgary and they’re still building new business.

As to his parent company’s current problems, he says that they have “lost some assets through declines in asset value as most management firms have,” but they “have a number of products doing quite well.”

Stuart points out that the company’s strength lies in its commitment to diversification, a core investment strategy that a lot of burned hedge funds failed to practice. “We’re not just trading equities, we’re trading the full gamut in markets around the world,” he says. “We trade both long and short, currencies, interest rate stocks, bonds — the tenet we have is to diversify.”

Stuart adds that the group has also a risk management process in place. It’s popular AHL offering targets annualized volatility first and returns second. “If markets get more volatile,” he says, “we tend to dial down the exposure we take in.”

Mark Purdy, managing director and CIO of Arrow Hedge Partners, echoes Stuart’s comments that diversification is paramount. He says his funds are generally performing well because they’re hedged and the investments within their funds offer downside protection. “We have a lot of funds in there that we don’t offer on a standalone basis that provides very good downside protection and we’re in there for that reason,” he says. “We’ve also paired off some of the managers that are more directional with managers that are really well hedged.”

So, while the more prudent hedge funds will remain, what will happen to the 40%-return-earners who have taken a huge hit in the last few months?

Purdy thinks they’ll stick around too, but that it will be up to investors to really understand what they’re buying. “People are going to have to evaluate a hedge fund on an individual basis,” he says. “Investors should pay close attention to strategy, fees, liquidity, but more important they should look for managers that have proven themselves through volatile periods, and there’s not a better test than what’s happened in the past 12 months.”

Schmitt agrees, saying that product knowledge is increasing, but investors need to ask the right questions before jumping into a fund. “A consumer should always question why they’re getting extraordinary returns,” he says. “That’s the process even on the long side.”

While Shaul says there is room for a hedge fund in a well diversified portfolio, it’s unclear what type of funds will be left standing. “The ones that should be considered in a hedge fund basket are the ones that have low correlation with major asset classes like equities and fixed income. Those are the ones that are going to be here,” he says. “The question of which ones will stay has to do with what sort of level of drawdown they’ve experience compared to the infrastructure they’ve set up and whether they can downsize fast enough.

“And, even for the ones that can downsize and can survive with a much lower asset base, will they run the fund for enough years to earn back that high water market?” he asks. “Performance bonuses don’t kick until that’s reached. Will that particular manager stick it out four or five years to get their 20% bonus or will they shut down and relaunch a year later?”

The hedge fund world is facing another crisis beyond who’s shutting their doors. Many investors have a negative view of the industry, and that needs to be fixed before confidence can return.

“There was a tendency on the part of a lot of investors and brokers to look at hedge funds as a bit of a fad chasing the latest high returns as opposed to looking at them as a basket of securities that’s part of a portfolio,” says Shaul. “For a lot of brokers it will be a while before they touch anything called a hedge fund. They won’t even address questions on whether this one or that one is different than the ones that got burned.”

Shaul is optimistic that when things have settled investors will take a “more sophisticated” approach to hedge funds and not look at them as the next big investment idea. Otherwise, “we’ll be back in the same situation again two years from now if all that happens is everyone jumps on something else that turns out to be the latest and greatest for a limited amount of time,” he explains.

In the end, most industry players are optimistic that hedge funds will not only survive, but they’ll come out stronger than they were before. “The opportunities are going to be very good because there will be fewer players and trades will be less crowded,” says Purdy. “And, when the market does comeback to a more fundamental view, stock pickers that have done well through this period will have the cash and ability to pick through bargains and improve their performance.”