the large private investment pools that have exploded in popularity this decade,
have hit their most challenging performance stretch in at least a year, raising
questions about whether their growth may be slowing and what that could mean
for global stock and bond markets.
in the average hedge fund dropped about 1.8% in April, according to
Hennessee Group LLC, a New York advisory firm for hedge-fund investors. In
all, returns are down 1.6% for the year.
While that doesn't sound like much, it could put pressure on some players
in the crowded, lightly regulated arena. Customers including big institutions,
pension funds and wealthy investors have flooded hedge funds in recent years
seeking outsized returns that aren't necessarily tied to moves in stock and
bond markets, unlike the returns of mutual funds and many other investment
make most of their profit from their investment gains, typically claiming
a hefty 20%. Without any gains, some funds could quickly lose key employees
or assets, if investors start demanding their money back.
industry has become so large that it has eliminated the very opportunities
it was seeking to exploit," says Joe Aaron, of San Francisco-based Wood,
Hat & Silver, which invests in hedge funds on behalf of investors but
has been pulling out of them lately. "For hedge funds, regression
to the mean has been faster than a speeding bullet. The good old days are
gone and may be gone forever."
...So far this
year, hedge funds have continued to outperform the overall stock market. Compared
with the 1.6% drop in return on investment that hedge funds experienced in
the first four months of 2005, the Standard & Poor's 500 index of 500
large, publicly traded stocks was down 4.5%. Over the past four years,
the average hedge fund gained 6.4% annually, compared with an average
annual gain of less than 2% for the S&P 500 and an average annual
gain of less than 1% for the Dow Jones Industrial Average.
Over the same period, hedge funds have seen their assets soar to about $1
trillion from about $400 billion, thanks to the influx of new investment and
the high returns.
funds are lagging behind bonds, which generally are viewed as safer
investments. The Lehman Brothers U.S. Aggregate Bond Index, a broad index
tracking bonds, is up 0.7% this year, through April. Some managers
say that because hedge funds generally aim for much less volatility, it's
unfair to compare them to broad stock and bond indexes.
affected are some of the biggest and best-known funds, including Caxton Associates
LLC of New York and Citadel Investment Group in Chicago, each of which has
an estimated $12 billion in assets. Each lost more than 2% in April,
according to investors. Representatives of Caxton and Citadel declined to
As they have grown, hedge funds, which have the leeway to invest more aggressively
than mutual funds and can use borrowed money, or leverage, to amplify their
returns, have become much bigger players in trading in stock and bond
markets, often through derivatives strategies. Problems at some funds could
rebound through global markets if they unwind their positions in stocks and
funds could seek to increase their leverage (borrowings) to make up for limp
returns. Federal Reserve Chairman Alan Greenspan recently warned about keeping
an eye on hedge-fund leverage.
A range of causes
explain the challenges for hedge funds. The recent drop in oil prices
has caused losses at commodity funds, while currency-oriented hedge funds
have been hurt by recent resilience in the dollar, which caught some
by surprise. As the hedge-fund field becomes more crowded, some managers find
their strategies are mimicked by other funds, making it harder to find opportunities.
Some hedge funds
have been betting against shares of General Motors Corp., which has
been suffering slumping sales and high costs. They took a hit last week when
investor Kirk Kerkorian disclosed that he wants to raise his stake in GM to
about 9%, helping the stock surge. At the same time, some funds betting against
the auto maker's shares also bought GM's bonds, figuring those bonds were
safer. But while Standard & Poor's decision to cut its credit rating on
GM to "junk" status last week caused the bonds to fall, it didn't
affect the stock as much, thanks to Mr. Kerkorian's interest. That hurt funds
making this bet.
area has been convertible bonds, which pay an interest rate, like any
other bond, but allow holders to convert them to stock from the issuer at
a preset price. By some analyst estimates, hedge funds own more than 75% of
all convertible bonds on the market.
Like other bonds,
convertibles have been dropping in price amid worries about the health
of the economy. That has sparked some investors to pull money out of convertible-bond
hedge funds, forcing the funds to sell convertibles to raise cash to pay back
their investors and putting even more pressure on the overall market. April
was the worst month in more than 15 years for convertible bonds, with convertible
hedge funds losing 3.5%, according to Goldman Sachs.
Because of the
hedge funds' complicated trading strategies, problems in convertible hedge
funds are spreading to other hedge funds that trade corporate debt, as well
as to the stock-oriented hedge funds that have been at the core of the hedge-fund
boom. Hedge funds known as "equity long/short funds," which
buy some shares while betting on others to fall in price, lost about 2.2%
on returns in April, according to the Hennessee Group, worse than the S&P
drop. They are one of the largest categories of hedge funds.
Many hedge funds
increasingly focus on credit-default swaps, or derivative securities
that serve as insurance protecting a holder against the default of a company.
If hedge funds see big losses they could be tempted to sell these derivative
positions, which in turn would weigh on the shares and bonds of the underlying
One of the hallmarks
of hedge funds is that investors can't just pull out their money any time
they wish to do so. Many funds require investors to exit only at the end of
the quarter -- at best. Some worry that at the end of the second quarter in
June, there will be significant withdrawals.
is how many hedge funds will pack it in," says Marc Freed, a managing
director at Lyster Watson & Co., which invests in dozens of hedge funds
on behalf of both individual and institutional clients. Mr. Freed notes that
those funds that lost in April may have trouble making up those losses in
a challenging market.
That will be
a key test. Similar scares appeared in the spring of 2003 and 2004, but were
overcome. Some industry experts say the difference now is that interest rates
are higher and many hedge funds themselves are relatively newer, with limited