Collapsing Hedge Fund Industry

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The past several years, the most valued people in our society were those who could make money from money. They weren’t cancer researchers or astrophysicists. They weren’t even the really important people, like N.B.A. players or movie stars. They were hedge fund managers. Last year, five of them made well over $1 billion each.

They scored, in part, by charging enormously high fees to investors who felt lucky just to be in business with them. The air of mystery that surrounded hedge fund managers—aided by their unregulated status and in some cases their black-box investing techniques—seemed only to bring in more money.

So much for that. The hedge fund mystique died with the crash of 2008. Youthful traders and big shots from investment banks won’t soon be given billions to invest based on their résumés. Mystery and opacity will be a negative, not cause for reward. Regulators, one hopes, are unlikely to again ignore an industry that, under their noses, grabbed at its peak nearly $2 trillion to manage.

As many as half the funds that existed earlier this year, when the industry topped out at 10,000 funds in business, could fail or be wound up in a year’s time, industry watchers estimate. Assets under management at hedge funds are falling as investors rush to pull money out of good funds and bad. In September, investors took out an estimated $41 billion from the sector, the largest monthly outflow of money since experts began tracking numbers. October looked even worse.

Washington is gunning for the industry. In a now-infamous memo, disgraced Lehman Brothers C.E.O. Dick Fuld reported disapprovingly that Treasury Secretary Hank Paulson wanted to “kill the bad [funds] and regulate the rest.” Regulators may soon have the chance. In November, managers of the biggest hedge funds will be dragged before Congress and given a roasting that could make the treatment of Fuld look cool by comparison. What will emerge from the heat is a smaller, more focused hedge fund industry, regulated by the federal government, with pay that better reflects long-term performance.

Many of the industry’s stars have been crushed. Tontine, a fund run by Jeff Gendell, one of the hot Greenwich, Connecticut, managers, was down 65 percent through September after a less than stellar 2007. Phil Falcone’s Harbinger had more than $20 billion under management after its main funds were up 116 percent in 2007; it was up 40 percent in the first half of 2008, before that gain was almost entirely wiped out in the third quarter. Steve Mandel’s legendary funds—among the so-called Tiger Cubs spun out of investor Julian Robertson’s company—were off between 23 and 31 percent this year through September, and an investor in his funds says that through mid-October, each of the funds was down another eight percentage points or so. Two funds run by onetime hockey player Tim Barakett’s Atticus were down 25 and 33 percent this year, and their assets under management fell by $5 billion, to $15 billion.

Many fund managers knew this day would come. They just thought it would happen to the other guy. Cliff Asness, a hedge fund manager and finance scholar, cautioned repeatedly in recent years about the faddishness of hedge funds. In 2004, he concluded, “The hedge fund structure does not create investing skill out of thin air…and the tools that hedge funds use (leverage, short-selling, and derivatives) certainly come with risk.”

At first, hedge funds were truly innovative. Eventually, though, so many new funds poured into the industry that they eroded the competitive advantage of the original investors. Hedge funds, it turns out, were not “hedged” in any meaningful sense of the word. Too few shorted enough stock or managed risk prudently. Recent months have made it clear that hedge funds as an industry were, as the wisecrack had it, a pay scheme masquerading as an asset class. Sure, many funds have their “high-water marks,” meaning they don’t receive their performance fees until they get back to the levels they had achieved at the peak. But many won’t bother staying in business.

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