Hedge funds return to roots as alpha claim refuted

By Laurence Fletcher - Analysis

LONDON (Reuters) - Hedge funds are set to return to their roots as niche products for the happy few as they have been unable to deliver the gleaming returns they were promising ever since the start of the credit crisis.

Hedge fund managers have long been flaunting alpha -- returns down to their skills to beat markets by using advanced investment techniques -- but many were caught short just as any other investor in this year's protracted downturn.

The industry now faces rapid shrinkage driven by losses of more than 20 percent, as measured by Hedge Fund Research's daily HFRX index, and redemptions that are predicted at somewhere between "large" and "catastrophic."

"Eighty percent of the hedge fund sector will not be here in three to four months," Robert McAdie, a credit strategist at Barclays Capital, said at a recent briefing. "Levered strategies are dead in this environment."

Funds have delivered worst-ever losses of 17.70 percent in the 11 months to November, according to Hedge Fund Research, as stocks have slumped and volatility has surged.

The first hedge fund was set up in 1949 by Alfred Winslow Jones with the aim of hedging a portfolio of longs (bets on rising prices) with a portfolio of shorts (bets on falling prices). It was followed by a range of other funds in the 1960s, including legendary manager George Soros's Quantum fund.

In the early days hedge funds tended to be run by some of the brightest stars in the financial services industry, who had a "go anywhere" remit and often the best access to brokers.

TWO IS A CROWD

However, hedge funds' early "crazy" spirit, as Eclectica Asset Management's Hugh Hendry has called it, has been diluted by a huge wave of investor flows that made it easier for less gifted managers to piggy-back on the real stars.

During the boom years of 2003-to-2007 assets swelled to as much as $2.6 trillion, and often two traders and a terminal were able to set up a long-short equity fund and quickly raise $50 million or $100 million from eager investors.

Pay cheques of $1 billion or even more for the top managers made headlines, and they charged hefty fees.

The credit crisis may have revealed what many were already suspecting -- that in many cases the prized alpha that many funds were supposedly producing was in fact beta -- or ordinary market performance -- repackaged.

Gains of nearly 20 percent in 2003 and roughly 10 percent a year in 2004-2007 coincided with rising equity markets.

With expectations of positive returns in all markets now shattered and redemptions flooding in, the industry is set to become much smaller again.

Such a position could ultimately prove much healthier for the industry.