Hedge funds came through the first three months of the credit crunch in reasonable shape.
But November is turning out to be a different proposition. Average returns look likely to be back in negative territory for the first time since August, judging by the performance of listed closed-end funds. More worrying, those average returns conceal big dispersions not just between strategies but within strategies, with performances varying from as much as 10% down to 5% up, according to prime brokers.
This kind of volatility doesn’t do much for the credibility of the industry, which sells itself on the basis of risk-adjusted returns. At the very least, it points to poor hedging strategies. Investors will ask whether it also points to inadequate risk controls. That will worry prime brokers too. Most include material adverse change clauses in their contracts, allowing them to withdraw financing and, if necessary, seize assets from funds that suffer major drawdowns.
No broker wants to finance a fund at risk of major redemptions and so far underwater that its managers are no longer incentivized to perform.
The credit crunch is also beginning to bear down on the hedge fund industry in other ways. The cost of financing has soared, particularly for credit funds that rely on the repo market. Banks are passing on their own higher funding costs, reflected in the rising London interbank offered rate (Libor), plus charging a higher spread. That alters the economics of the hedge fund industry—particularly for strategies such as credit funds, relative value and arbitrage funds, which depend on exploiting short -term pricing anomalies. Meanwhile, some hedge funds are voluntarily de-risking their portfolios because they fear banks will withdraw leverage. The result will be lower returns.
All this points to a tricky few months ahead. So far, redemptions have remained light through the credit crunch. But November’s figures are likely to trigger some soul-searching by investors, who will now have had several months to see how funds perform under pressure. Weak performers are likely to be jettisoned.
Given that most hedge fund investment these days is locked up for three months, the bulk of redemptions won’t take place until the first quarter of next year. That could be when the credit crunch catches up with hedge funds.