Hedge Funds: The Next Shoe to Drop

You think things are bad now? Just you wait: the chart above gives you a very good indication of what Christine Williamson calls the "bloodbath ahead" in the hedge-fund industry.

No one wants to be invested in an underperforming hedge fund right now -- and half of the hedge funds in America are underperforming. What happens when investors decide to take their money out tomorrow, as they're generally allowed to do on the first day of any quarter?

Sources said they expect the body count to total as many as 2,000 hedge funds and 500 hedge funds of funds between now and the end of March...
Most hedge funds operate on an end-of-quarter deadline for requests from clients to have their money returned. If experts' predictions of very large collective redemptions come true, managers will have to liquidate their holdings en masse, pushing down prices and forcing many smaller hedge funds or those with poor returns out of business. The wave of closures could span six months, likely beginning in earnest in November and December at the end of the typical 45- or 65-day waiting period when fund managers have to return investor cash.

What you see in the chart is the enormous range of returns between the best-performing and wosrt-performing hedge funds -- a range which has never been wider. Ironically, it's the result of the fact that hedge-fund returns during the Great Moderation of 2002-7 were very closely grouped together -- something which prompted funds to take on extra leverage to boost their returns. In turn, all that extra leverage helps explain why the top 10% of funds is up more than 50% over the past 12 months, while the bottom 50% is down more than 25%.

It's not just redemptions which underperforming hedge funds have to worry about, either: it's also employees, who are going to have a much smaller performance-related bonus pot to split between them this year.

These problems are propping up elsewhere on the buy-side, too: according to the WSJ, the reason that Lehman Brothers ended up selling Neuberger Berman for $2.15 billion rather than somewhere between $7 billion and $13 billion was that

the deal was held up in recent weeks due in part to protracted contract negotiations with the Neuberger money managers. People involved the discussions have described the process of persuading them to sign on to the deal as something akin to "herding cats."

Could it be that all these fund managers were simply paid far too much money over the past few years? After all, they can't all find well-remunerated work elsewhere. But for many of them, that probably doesn't matter: they can live quite comfortably off what they've earned already, and if they feel like making more they can just start investing their own funds, without having to worry about office politics or the trader sitting next to them blowing up the entire firm.

In any event, the hedge-fund shakeout over the coming months could be brutal, and have nasty systemic consequences if hundreds or thousands of hedge funds are all trying to unwind their positions at the same time. In the worst-case scenario, a fund which wrote a lot of credit protection could go bust, leaving its investors with nothing and its counterparties with very little. If the counterparty dominoes then started to fall, the financial system could end up in much worse shape than anything we've seen so far.

(HT: Gumby)

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