The Decline in Profits in Recent Years

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Introductory Abstract

This paper traces the origin of hedge funds as an alternate investment instrument, particularly in the US financial markets. It also attempts to highlight the peculiar characteristics of hedge funds that make it different from other funds like mutual funds, list specific benefits of investing in hedge funds, as also mention the main risks or downsides that such funds have.

Thus, while hedge funds are less transparent, need not be subject to disclosure mandates and consist of pooled funds that are invested for reaping substantial returns by way of arbitrages, derivatives, etc., obvious risks in hedge fund investment include these same characteristics of lack of transparency and regulatory restrictions that can play havoc in times of financial crisis as has happened in 2007 and 2008.

Additionally, need for skills in fund managers, diversified nature of investments, high investments required, medium liquidity of the funds by nature, and legal stipulations as to the constitution and structure of hedge funds in the US are the subject of study in the following pages and subsequent pages shed light on the causes and circumstances of the recent hedge fund declines and collapses and the reasons for the same.

Most fund agencies and companies had reported the decline in performances in the latter part of 2008 and some funds had even been closed by the emerging downturn and sequence of events, particularly relating to the sub-prime crisis, and the effect on the hedge funds were mostly due to the funds having invested in those sub-prime securities built upon underlying home mortgages to the economically weaker households.

What Are Hedge Funds?

Hedge funds are leveraged speculative funds. Ordower, H. has defined hedge funds as “actively managed investments which are essentially the pooling of investors’ capital so as to acquire own or trade securities, financial products or commodities” (324). Walsh, K M of the US Federal Reserve System has observed that “while there may not be a precise legal definition of hedge funds, hedge funds are without doubt, pooled vehicles that are privately set up, administered by a professional investment manager and are generally not available to the public at large” (Testimony before Committee on Financial Services, 11 Jul, 2007, Original Speech, p. 2).

Blundell-Wignall, A. in his paper on Financial Market Trends in Jan, 2007, defines hedge fund as lightly-regulated managers of private capital using an active investment approach for gaining from arbitrage opportunities that arise in cases of mis-pricing of financial instruments and also mentions that hedge funds commonly employ leverage and derivatives to achieve their ends (p. 40). Kolb, R.W. and Overdahl, J.A. define a hedge fund as a private investment partnership, accessible only to large investors, and is unregulated by the rules governing other investment companies.

They maintain that hedge funds can employ any trading strategy they choose, including highly risky strategies, and therefore, the term “hedge” is misleading in describing the risk appetite of the fund’s investors (pp. 262-263) Shadab, H.B. states in the New York University Journal of Legislation and Public Policy that the words ‘Hedge fund’ apply to quite diverse category of investment funds, which do not always hedge their investments. While the U.S. securities law does not define hedge funds, a hedge fund is widely thought of as private investment pools not subject to full range of investment restrictions on activities and disclosure requirements which are imposed by the US Federal Security Laws on other investments.

Hedge funds thus frequently trade in securities and financial derivatives, although most hedge funds do make relatively long-term investments and often make non-financial investments. Hedge funds differ from other types of private investment funds in that they calculate and provide for managerial performance fees on yearly or quarterly basis, irrespective of nil investments traded and any gains or losses affected (p. 75).

King, M.R. and Maier, P. observe in their Bank of Canada Discussion Paper that hedge funds are largely created to circumvent the legal restrictions imposed on mutual funds and are usually in the nature of a private investment firm that adopts aggressive trading tactics like short sales, program trading, leverage, arbitrage or derivative trading for earning positive returns from the market. Hedge funds are usually formed as a partnership or LLC for managing funds derived from a small number of rich individual and institutional Investors, need not be registered, require substantially high minimum investments, restrict withdrawals, and generally have low transparency, and limited disclosure obligations (p. 20).

Hedge fund is a mutual fund with deals with speculative investments in equities. Opening positions to other companies working in the same sphere, such a fund simultaneously acts in an opposite direction with the purpose of reducing the level of general risk. Hedge fund can also be defined as the one using leverage and various hedging techniques; at this, leverage is a correlation of capital investments into fixed income securities (for instance, bonds and preferred stocks) and unfixed income securities (correspondingly, common shares).

Hedge funds can also be represented by private investment partnerships with a number of partners being legally restricted by Securities and Exchange Commission (usually up to ninety nine), and, as a rule, they are offshore companies. At least sixty five out of ninety nine companies should be accredited; this status is given to an investor on the basis of criterion of net value of stock investment which also has its certain limits. Hedge funds apply methods and instruments the usage of which is limited within the sphere of activities of mutual funds; this commonly includes short selling, hedging by means of urgent tools, and wide usage of leverage.

Hedge fund is a flexible investment fund for solvent private investors and companies with minimal investment cost of one million dollars; it is aimed at getting absolute profit in any possible way. What is also notable is that hedge funds, unlike the mutual ones, are always capable of getting profits irrespective of the current market position.

Hedge fond is, as a rule, a private investment partnership which invests funds for the most part into securities or derivative financial tools. Some of the funds do not limit their activities by trading securities and work, for instance, at commodity markets. There exist two kinds of partners in a hedge fund: General Partner and Limited Partner. General Partner is the founder of the fund and is in charge of the every-day activities of the operating fund.

He gets stimulating payment for all kinds of services he renders; this sum is stipulated in the partnership agreement and usually makes approximately 20% from total of net assets. He also gets administrative payment of 2-3% from total of net assets. The profits of the hedge fund are distributed among all the partners in proportion to their share in capital and all the relationships between the Partners are specified in details in the partnership agreement which is the most significant part of any hedge fund.

Limited Partners participate in hedge fund’s activities by means of investing capital without taking direct part in trade or every-day activities of the fund. Limited Liability Company is a typical form of organization for the General Partner; at this, the founder overtakes all the liabilities whereas the Limited Partner of the investment partnership is responsible only in frames of his own investments.

Hedge fund differs from other financial institutions mostly by its freedom in choosing investment style and boundless investment strategies it can practise. Hedge funds’ managers use diverse possibilities of the market of derived financial tools more freely than other forms of investment organizations.

The Origin and Growth of Hedge Funds

Makin, J.H. has traced in an article the origin of hedge funds and has also given a brief history of the events unfolding till the present time. He maintains that hedge funds originated in an environment where mutual funds predominated as investment instruments post World War II in the US capital markets and due to the long only nature of the investments. In contrast with mutual funds, hedge funds could offer both long and short decisions on any commodity, stock, bond, etc that moved and could be traded. However, it was Alfred W. Jones, who set up the first modern hedge fund way back in 1949.

In general, Jones’ fund was based on three main principles. First of all, private partnership as a juridical form of fund organization was used in order to ensure maximal flexibility of managing the fund; secondly, it was characterized by short selling; and thirdly, it applied leverage (loan capital was used for reducing the private capital necessary for investments with the purpose of increasing profitability of the capital). His hedge fund was actually an equity fund set up as a private partnership which was hence exempt from regulations of the SEC. He based his strategy on the premise of judicious selection of long and short stocks based on rising or falling trends in the market.

This was a basic concept that in a portfolio of stocks, one could hold long those stocks that were rising and hold less or short those stocks that were falling. Of course, correct forecasting of which stocks would go which way, up or down, would require an expert to take the helm of strategies the fund. An appropriate mix of long and short stocks would guarantee returns from the investments in the fund over the long term and this irrespective of the rising or falling trends of the market itself. Jones’ innovation grew steadily during 1950s to the 1980s.

As long as financial system of the USA was steady, American dollar was stable, and certain growth could be observed at the equity markets, hedge funds remained in shadow and did not attract attention of investors. Though when macroeconomic environment changed for worse, exchange market became unstable, unsteadiness at the stock markets started increasing, and the activity rates of the traditional mutual funds reduced, the specialists returned to the idea of using hedge funds which not only guaranteed increased profits but reduced investment risks. From the very beginning, characteristic feature of hedge funds was their hedging of market positions from the possible landslide of prices. Short selling used to be the only method of hedging portfolio securities before the emergence of futures contracts, options and other industrial financial tools.

Hedging portfolio securities consisted in borrowing securities from a broker, selling them at the exchange, and afterwards, buying them back at the reduced price. It is believed that such a practice existed already at the beginning of the twentieth century. However, hedge funds as alternate investment instruments really took off from the 1990s onwards. The SEC, prior to the recent financial crisis, had even estimated in a report in 2003 that hedge funds would grow to over USD1 trillion between the years 2008 and 2010. The hedge fund industry has shown phenomenal growth both in developed countries and in the developing countries. As per one estimate the total assets under management (AUM) of hedge funds (HF) have increased 5-fold since 1999, and to USD 1.6 trillion at end of 2006.

The numbers of hedge funds have also leaped to 9,000 as per a report from FSF in 2007. As per another estimate in 2007, between 2004 and 2006, alone, the AUM increased in developing economies by as much as USD 175 billion (Laurelli, p 18).

*Fig.1 Emerging Markets HF Asset Focus.*

Recently, the markets saw the funds of funds emergence. Such kinds of funds make it possible to invest in ten or even more hedge funds simultaneously. This wide diversification tangibly limits potential risk typical for the strategy of a separate hedge fund. This type of funds proved to be convenient; it is complicated to achieve such a diversification even for rich investors because of high rates of minimal investments into the hedge funds. Today there exist more then five thousand hedge funds which operate over five billion dollars. All the companies and private individuals including pension funds, private clinics and universities, as well as family funds, invest into these hedge funds.

Types, Nature, Size, and Structure of Hedge Funds

While originally hedges were conceived as arbitrages which tried to leverage their positions for higher returns on investments by tapping on mis-pricing opportunities existing in the market, nowadays, hedge funds aggressively undertake speculation in the market by leveraging on available mis-priced opportunities or on perceived macro-economic or structural market changes in future. The various types of hedge funds broadly include the global macro funds, event-driven funds and market-neutral funds.

Accordingly, investment managers base their hedge fund decisions based on global macro economic environment, invest funds in securities relating to events like bankruptcies, mergers and acquisitions, and/or target value trade by offsetting positions of assets having favorable forecast in the markets. However, other experts classify hedge funds into Directional, Event-driven, Market Neutral, Others and Fund of Funds based on AUM by investment strategy.

Broadly, however, the funds may be directional, event driven or market neutral. The Directional funds have lowest leverage but they constitute the major share of total hedge funds. Such funds include macro, long-short equity, emerging markets, managed futures and dedicated short bias. Event driven funds have higher volatility in investment returns. The market neutral category of funds includes convertible, fixed income arbitrages, etc. But the most unique innovation appears to be the fourth category of Fund of Funds or FOF. These take positions in other HFs thereby letting in more low net worth investors and also diversifying the funds in constitution, geographical extent, and risk factor.

Hedge funds are also classified based on investment style (e.g., relative value) and in each style category, funds are sub-classified according to underlying markets traded. Thus, within relative value style classification, exist a number of sub-groups, like long/short equity, convertible hedging, bond hedging and so on. EACM classifies hedge funds into the categories Relative Value, Event-driven, Equity hedge Funds, Global Asset Allocators, and Short Selling Hedge Funds (Schneeweis, T. And Georgiev, G., pp. 1-2)

Generally, all hedge funds undertake strategies like arbitrage, derivative trading, short sales, leverage, program trading etc and essentially control the funds of a selected number of wealth investors. The minimum investment amounts specified are also quite high, the fees are higher and include both a fixed management fee and a performance fee tied to profits, and there are always restrictions on withdrawals from the fund. This coupled with low transparency and minimum disclosure requirements tend to make the hedge funds an opaque instrument subject to obvious risks from the fluctuations in the market in so far as investment of the funds in a volatile market are concerned.

An important characteristic of hedge funds as compared to mutual funds was that, unlike mutual funds which were highly regulated, transparent and subject to various legal restrictions, these were free of all such restrictions and fund managers could hope to improve returns on investments as also pocket all individual incentives based on high performance assets. Unlike mutual funds, which could only bring in profits in relative terms, hedge funds could bring in actual and absolute profits on investments and fund managers had a free run of the market as the perceived risks of failure were thought to be negligible. This perhaps explains the rampant growth of the hedge fund sector as a part of the overall financial sector across the world whether in developed countries like the US or in lesser economic forces like the Asian countries, China and Malaysia.

In one estimate in 2007, the International Monetary Fund (IMF) has estimated that there were more than 9,000 hedge funds by the end of 2006, with AUM of $1.34 trillion, and an average size of around $150 million (USD). Since hedge funds are unregistered, it has been difficult estimating the size of their market. However some agents have calculated the size. For example, Hedgefund.net has estimated the total administered hedge funds to be in the range of USD 2.26 trillion as at the end of the 1^st financial quarter of 2007, while Maslakovic, M. of the IFS has estimated the same to be around USD 1.5 trillion.

Benefits of Hedge Funds

The most obvious benefit that hedge funds afford investors and fund managers alike is in the degree of freedom to invest large funds for deriving profits. Since in case of normal investment avenues, risks are sought to be minimized through legal regulatory framework and disclosure mandates, the absence of either disclosure requirements or transparency of operations provides fund investors that much more leeway to profitably invest their funds. Like mutual funds, massive assets may be accumulated from a number of cash-rich investors and diversified investments provide the necessary cushion to tackle market and operational risks.

Also, unlike mutual funds, hedge funds do not need the daily redemption liquidity (an open-end fund) or the public market for trading (a closed-end fund). Also unlike mutual funds, hedge funds allow managers to have direct share of investment gains (Ordower, H., p. 330). As investment instruments, hedge are only moderately illiquid, trade cash or derivatives, they do reduce portfolio volatility risk, offer alternate investment in new, versatile and structured products, and can substantially enhance returns on assets. Hedge fund returns were also considered absolute returns as these were supposedly not influenced by traditional stocks and markets.

*Fig. 2: Total Investment in Hedge Funds.*

The main differences between a hedge fund and a mutual fund lie in the regulation of their structures. The matter is that mutual funds are limited by investments into securities, such as stocks, bonds, and mortgages. Hedge funds, in their turn, can not only invest into all the tools possible for a mutual fund to invest into but use short selling, options, warrants, convertible bonds, and margin transactions, which explains their successful performance even when the market is in decline.

Moreover, investment companies possess and manage mutual funds. The capital is gathered in a way which allows the investment company to invest only a small part of its own money; profits, as well as expenses, are distributed among the investors in proportion to their participation. Almost the same situation can be observed in the hedge fund but the difference is in managers’ distribution of their own money in a hedge fund, which is usually a common case.

Additional profits obtained by managers depend on a certain rate of return on investments which should not be less than a certain sum of money stipulated in the partnership agreement. Another significant advantage of the hedge funds lies in availability of a wide range of strategies. Hedge funds’ managers can apply the strategies the mutual funds are not allowed to. Correspondingly, the return on investments is higher when the risk is relatively low.

What else should be mentioned is that entering a hedge fund on the rights of a partner is considered to be one of the best ways of investment organization in foreign markets of capitals. Uniting money resources with investment purposes, the individuals who enter a hedge fund save money on the expenses, considerably reduce risks and have a complete access to the information regarding their accounts. These facts allure a number of investors since they bring net income and ensure favorable conditions for distributing money within markets of capitals, as well as they are far more beneficial than opening a separate investment account with investment companies.

Moreover, hedge funds offer a wider range of services than other professional organizations, especially when it comes to securities. Founding the hedge fund structured as a separate organization has beneficial prospects, particularly when it does not contradict to the general business context. The diversity of the financial instruments which can be observed at the market these days demands significant efforts to perform all the operations synchronously this is why hedge fund is an obligatory element of the modern financial management. A hedge fund is free in choosing management principles and is able to solve problems in the sphere of financial engineering, which is a motive power in the market of offering services in managing assets and liabilities.

However, Jones, R. of the FSA, the UK, maintains that while hedge funds do contribute to financial market diversification and growth, provide liquidity and are fundamental for the efficient reallocation of risk and capital, they also disrupt the markets due to the recent failure of significantly large and vulnerable hedge funds and potentially or actually erode investor confidence as also the confidence of related counterparties.

The highly leveraged and concentrated high investments in specific market segments and instruments could also result in a substantial liquidity mismatch leading to run on assets which in turn could lead to disorderly markets. Other risks are those due to lack of transparency, sufficient information to inform regulatory action and optimal skills in fund managers to create an effective control system. Additionally, asset valuation methods are weak and there is inherent conflict of interests as also increasing incidences of insider trading and manipulative of markets (Jones, R., the FSA, pp. 1-6).

Management of Hedge Funds

The structured nature of the hedge funds as also the high degree of leverages utilized in investment decisions for adding value to the hedge fund necessarily requires the services of expert management at the helm of affairs at the hedge fund, which is usually constituted as a limited partnership. In addition to managing the funds in a fiduciary capacity, the fund managers also invest in the funds.

And, accurate analysis of market trends as also appropriate decision making skills are essential for a fund manager to successfully bring in profits. In the case of a financial instrument of any kind, and in view of the unpredictable nature of financial markets, the manager of hedge funds does need to apply his skills in risk management in addition to strategizing for improving return on investments. A contentious issue in the present times due to the declining profits is the one of need for fund managers to pocket high fees, even when so many hedge funds have collapsed or just been saved by concerted governmental action. Fung, W.K.H. and Hsieh, D.A. in a paper presented in 2006 aver that hedge fund managers are ultimately guided by desire for maximizing enterprise value of firms (p. 2).

Managing a hedge fund can involve a number of problems, such as, for instance, of a problem of managing the risks connected with performing export-import operations. A legally founded hedge fund can cope with a number of problems by controlling the whole chain of operations, which can increase the productivity of the main business. This type of financial institutes is of great interest to the companies working in the sphere of financial services and, in the first place, to the banks. Possessing an active hedge fund as an investment institution, any banking establishment or investment company can offer more services not only in terms of quantity but qualitatively as well.

Laws Concerning Hedge Funds

Laws concerning Hedge Fund operations in the United States include the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act of 1940, the Investment Advisors Act of 1940, the Internal Revenue Code of 1986 and the Commodities Exchange Act. However, these Acts contain provisions to exempt hedge funds from their regulation and only apply in case of inappropriate structuring of hedge funds.

So that hedge funds may avail leverage through borrowing, the same should not be structured as registered investment companies (15 U.S.C. § 80a-18 of the Investment Companies Act). Section 80a–3(c)(1) (“section 3c1”), funds of the same Act limits the number of the beneficial owners of the shares of hedge funds to one hundred while Section 80a–3(c)(7) (“section 3c7”), funds limits their investors to qualified purchasers, who individually own at least USD 5 million in investments.

Since the SEC imposes disclosure requirements on security sale to unaccredited investor(s) and which consequently invite registration, and since accepting unaccredited investors in a total strength of maximum hundred investors would only diminish the hedge fund’s capital raising abilities, hedge funds invite only accredited investors having the economic the minimum mandatory USD 1 million of assets, subject to enhancement by law (proposed) to USD 2.5 million in assets. Law also permits hedge funds to invest in other hedge funds (Ordower, H., p. 330).

Introduction of separate laws for hedge funds was necessary in order to reduce the cases of fraud which could be observed in the USA in the period from 1999 till 2004 when SEC opened 51 cases on swindle. Perpetrating a fraud, the hedge funds work together with broker companies and mutual investment funds which actively perform operations at the stock markets and have an opportunity to buy, sell, or exchange securities.

Market timing and late trading are two of the most wide-spread types of fraud practised by the hedge funds. Market-timing, in general, is not illegal and is used while working out investment strategies. Though in some cases it is used for a large amount of operations on buying and selling one and the same mutual investment fund, which is unfavorable for the fund’s investors since active purchase or selling of stocks can reduce their value. What’s more, in this case market-timing affects managing the investment portfolios and increases expenses because of numerous trade operations.

For settling with market timers mutual funds need to have significant sum of cash money, which reduces liquidity and involves other inconveniences. During the crisis on the stock market some managers of the mutual funds sign secret agreements with institutional investors, mostly with hedge funds. As a result, hedge funds can also conduct illegal trade operations in exchange for paying mutual investment companies correspondent fees which are then fully covered by the profits obtained from market-timing. Mutual funds forbid market-timing and trace carefully the investors’ activities. To achieve this, certain analytical departments function within the funds; they analyze the frequency of conducted operations and rates of transactions performed by the investors.

If the obtained data exceed the existing norms, mutual funds block further operations of the investors. Late trading, in its turn, is buying, selling or exchanging stocks of the mutual fund with delay, in other words, when the sale is already over (this is usually after 4 p.m. according to West-European time after counting the net asset value and setting the value of stocks for the following day). Approximately around 4:30 and 5 p.m. there appears the information about the state of stock market and futures market for the following day.

In case of a predicted market growth, hedge funds, using the late trading, buy up the stocks of a separate mutual fund at the previous price and sell them the next day with profits. Hedge funds which apply late trading have certain advantages since they possess information about the market growth which most of other investors do not have access to. Thus, the Investment Company Act forbids late trading because it makes the investors unequal. However, the provisions of the Investment Company Act do not spread over American hedge funds; therefore, they are more legally free as compared to other participants of the market.

Recent Performances of Hedge Funds

The HFR Group in Oct 2008 reported that panic stricken Investors had withdrawn around USD 31 billion in the past quarter which was the worst in the hedge fund industry till date. The hedge fund asset size was reduced by s much as USD 210 billion in the 3rd Quarter of 2008. The total capital stood reduced from USD 1.93 trillion to a much lower USD 1.72 trillion during the same period. HFR also reported that their broad-based HFRI Fund Weighted Composite Index had also declined by 8.85 percent in the 3rd quarter 2008 while the average hedge fund declined by 1.45 percent. While most geographical regions faced this decline, the largest such was from the North American and Global exposures. HFR also maintained that 2008 was the worst year in hedge fund industry history in terms of both performance and asset flows.

Likewise, the Hennessee Group LLC based in New York, reported that total hedge-fund assets declined by 39% to $1.21 trillion in 2008 which was their lowest post 2006. Investors redeemed as much as USD 399 billion worth of assets and negative performances also caused nearly USD 382 billion to cause overall a USD 781 billion reduction. Asset reduction of 19% due to declining performance was the worst faced by the Hennessee Group. Additionally, the Bernard Madoff scandal reflected adversely on the industry (www.investmentnews.com).

A third data provider, Eureka Hedge based at Singapore also furnished details of decline in 2008, stating that their funds had lost as much as USD 350 billion globally, of which almost 90 percent occurred in latter part of the year. The North American segment declined the most and recorded net decline of USD 183 billion that year. By its estimates, Eureka maintained that the hedge fund industry had shrink by a fifth of the previous figure, from USD 1.9 trillion to a lower USD 1.5 trillion.

Among the hedge funds, a leading fund Citadel Investment Group LLC suffered maximum losses. Even banks withdrew credit to the hedge funds, which showed a loss of 2.3 per cent, resulting in a massive liquidity (www.btimes.com.my). A major event has been the collapse of the Lehman Brothers Holdings Inc in September which started the crisis that halved the value of equity markets across the world to USD 30 trillion in 2008. Also, the MSCI World Index, which tracks shares across 23 developed nations, took a record 42 per cent downturn caused by credit linked losses of USD1 trillion. Both Lehman’s demise and the Madoff scandal made hedge funds take a tumble, primarily those that relied on investment banks’ prime brokerages for their credit, trading and administrative functions. Hedge Fund markets thus witnessed massive redemption sprees.

Distressed debts contributed to declining hedge funds. Almost 7 percent of the entire industry-around 700 hedge funds-had actually collapsed in 2008, according to Hedge Fund Research. And the large scale investor redemptions forced many hedge funds to liquidate large chunks of their assets, triggering “dramatic” swings in the stock market.

Hedge Funds Losses in Recent Years and Sub-prime Crisis

As the markets collapsed suddenly, and the Madoff scandal widened, hedge funds began a decline which was one of the worst in their history. Greed for more profits from fund managers as also huger for individual incentives most probably precipitated much of the crisis. However, part blame could also be attributed to lack of regulator control over an industry which was always prone to risks from its investments in the volatile market.

Most of the loss of hedge funds could be tracked to the pattern of investments by individual funds. Many hedge funds had unwittingly invested in the sub-prime stocks, which actually related to home mortgages for lower income households in the US, as per governmental policy prevailing in the country. Most fund managers were driven by profit motives rather than take a more defensive risk management approach.

Many hedge funds traded in crude oil and soybean futures, derivatives and other exotic assets out of reach to ordinary investors inviting typically a yearly manager fee of 2 percent of assets and 20 percent of profits. While many had redeemed their money, many hedge funds imposed lock-ins thereby preventing many more investors from withdrawing their money fearing that declining assets could destroy their business forever.

In a chain sequence, investors also withdrew money from wealthier funds, which were thus forced also to convert to liquidity via asset sales to meet emergent credit needs, in as much as banks had become shy to deliver credit to hedge funds. Additionally, the Madoff scandal made the far safer Fund of Funds category of hedge funds also a victim of the declining trends & industry losses. With the decline in number of FOF s, fewer investments flew into the traditional hedge funds.

Reasons for the Decline in Performances of Major Hedge Funds

Wignall maintains that hedge funds since they borrow from prime brokers were affected and indirectly affected the banks. Also, hedge funds own most of the risky CDO tranches and thus, while hedge funds have around 46% of the exposure, banks have only 25%, asset managers 19% and insurance 10% of the exposure. It is also estimated that hedge fund exposure at the high risk tranche end could be somewhere between USD 300 & 400 billion. Hedge funds having mortgage related exposures to equity and BB CDO tranches were the worst affected.

Conclusion

Wignall recommends that restructuring and reabsorption of assets into large institutions could play a crucial role in the financial market turnaround. He also avers that an optimum balance of funding and lending is critical to the issue of restoring the economy and imparting confidence among investors. Another factor that needs a re-look could be the massive amount of manager’s fees that are pocketed even in times of crisis, as also the role played by rating agencies which actually influence the hedge fund performances in as much as the process of rating is linked to the investor credit worth.

References

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