LONDON The European fund of hedge funds industry may shrink to a quarter of its size as hits from currency hedges and the withdrawal of bank funding compound problems in a sector still reeling from the Madoff scandal.
The shake-up could see strong funds of funds buy weaker rivals, as some in the market question a business model that charges a premium for selecting the best managers -- but underperformed benchmark hedge fund indices.
"I think outflows will be at least in line with the overall hedge fund industry, and could easily be 50 percent or even more than that," said Chris Manser, global head, fund of hedge funds at AXA Investment Managers.
"I think we'll see a lot of consolidation, and increasingly managers just going out of business," added Manser, whose flagship fund was down 8 percent in 2008. In total, Manser runs 3.5 billion euros ($4.48 billion) in assets.
Redemptions of 50 percent, plus last year's losses, mean the industry could end up 75 percent smaller than the start of 2008.
Within the closed-end sector, meanwhile, investor appetite for funds of hedge funds has weakened, with funds now on an average discount to net asset value of more than 20 percent.
"(With) the whole fund of funds universe, a lot of people are questioning whether that is an effective business model," Tom Anderson, hedge fund manager at Yorkville Advisors, said.
Funds of funds account for around 40 percent of the overall hedge fund industry, and surprised last year by performing worse on average than for single manager hedge funds.
Hedge Fund Research's HFRI Fund of Funds index fell 19.97 percent in 2008, with only three months out of 12 positive. By comparison, hedge funds lost 18.30 percent.
Margin calls on currency hedges after the dollar's rapid rise will be another blow, forcing fund-of-funds to pay out hundreds of millions of dollars, money that could otherwise have been used to meet client redemptions.
European funds of hedge funds' assets tend to be dollar-denominated hedge funds, but their liabilities -- what they have to give back to investors at some point in the future -- are usually in pounds, euros or Swiss francs.
Most therefore put in a currency hedge, which protects them from a weakening dollar but hurts when the dollar strengthens.
After the dollar's recent rise -- the British pound has weakened from around $1.85 in September to below $1.40 last month, while the euro has weakened from nearly $1.50 to below $1.30 -- many have had to stump up cash to meet margin calls.
While this does not represent a financial loss -- their new, lower dollar holdings still equal the same amount in sterling or euros -- the ready cash was vital in meeting client redemptions when some holdings are hard to exit.
Dexion Absolute DAB.L, a listed fund of hedge funds, had to pay out a staggering 20 percent of its net asset value, or 250 million pounds in cash, on a currency margin call, meaning it could not use the money to buy back its own shares.
Moreover, the problem has been compounded after some banks withdrew credit lines to funds after the Madoff scandal.
"The currency drain would be a constant drain on a fund of hedge fund's cash, when cash is already tight due to redemptions -- it's a double whammy," said AXA's Manser.
"With a stronger dollar and client redemptions, losing the credit line can be another blow to a fund of funds liquidity, and could be too much to manage."
Funds face the problem of how to raise cash, without selling liquid holdings and leaving investors with an illiquid rump.
Many, such as Thames River Capital's funds, have told clients they can only draw out their money every 90 days, and those that survive the downturn may have to invest in more liquid assets or lock up investors for longer.
"There are some fundamental issues with funds of funds that have become apparent, particularly that of liquidity and asset-liability mismatches," said Odi Lahav, vice president at rating agency Moody's alternative investment group.
"These in themselves will probably cause investors to submit more redemptions than they would have otherwise and put pressure on the business models to change, either toward managed accounts or less favorable redemptions terms for investors."
(Editing by David Cowell)