July 31, 2007 / 8:25 PM / in 10 years

Sowood hedge fund collapse sparks fear, little else

BOSTON, July 31 (Reuters) - Hedge fund Sowood Capital’s spectacular collapse this week sparked fears more funds may be on the brink, but its impact on the overall health of the industry will be small, investors and analysts said Tuesday.

The Boston-based hedge fund, which managed money for Harvard University, lost roughly half of its $3 billion in capital in less than a month, becoming the first high-profile victim of the recent credit market woes.

People who passed on Sowood when Jeff Larson launched the fund three years ago called the decline “unbelievable” and “shocking” on Tuesday, and several blamed weak risk management for the fund’s death spiral.

These hedge fund investors also said the bad fortune of Sowood clients would be more personally painful than harmful for the broader $1.75 trillion hedge industry, where returns for July were flat, according to data from some industry trackers.

“I bet there will be as many winners as losers and that the overall impact won’t be big,” said Phillip Maisano, Head of Alternative Investments at BNY Mellon Asset Management.

Jaeson Dubrovay, who heads the hedge fund practice at New England Pension Consultants, said Sowood’s demise, while noteworthy because the fund was well-respected for a time, “is just going to be a blip” for the industry.

One reason Sowood’s losses will not unhinge financial markets may be that rival hedge fund Citadel Investments Group, which is nearly five times as big as Sowood was, snapped up its ailing credit portfolio.

“Citadel’s Ken Griffin has the advantage of having more liquidity and being able to wait it out longer,” Maisano said, adding: “He will probably make money on these positions in the long run.”

Citadel, which snapped distressed rival Amaranth Advisors’ energy portfolio last year, has helped calm markets, investors agreed.

But investors also said nervousness was lingering and could give rise to speculation about other funds going under.

“For the next month, we are not going to be out of the woods quite yet,” said Charles Gradante, principal at Hennessee Group, which invests in hedge funds and tracks their returns.

While Sowood’s pedigree and connections to big-name funds helped resolve its crisis quickly, other troubled funds may not be so lucky. This means talk of more funds going under is going to pick up, investors agreed. They also said redemptions could begin to pile up at smaller funds. Those specializing in fixed income strategies especially could see assets flee over the next few months.

In the first quarter, hedge funds specializing in distressed securities pulled in $7.5 billion, while fixed income arbitrage funds added $2.6 billion, according to data from Hedge Fund Research.

“Fear can’t be quantified, but I would not be surprised if these market moves lead to exaggerated flows out of these strategies,” Gradante said.

At the same time, though, plenty of funds are starting up or expanding their capacity to pick troubled assets. Michael Vranos’ Ellington Management, known for its expertise in mortgage securities, is hoping to woo institutional investors with a new portfolio aimed at distressed mortgages and Jim Midanek’s Black Pearl Asset Management is readying to buy up the same.

“There is still a lot of demand for this out there and there will be winners just as there will be losers,” NEPC’s Dubrovay said.

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