Will Panicking Investors Desert Hedge Funds?

by Carla Johnson, Investors Offshore, London

14 October 2002

When major hedge fund indices show losses, as was the case in September, and just a month earlier for July, hedge fund managers start checking for the ejector seat controls. Their remuneration depends critically in most cases on making profits, and if there are not going to be any profits they would be better off running a nice, comfortable index-tracking mutual fund which may not be going to make anyone rich but will at least buy the Xmas turkey.

The Hennessee Hedge Fund Index fell 1.3% for September, and the Van Hedge Fund Index fell 1.2%. Researchers at Tremont Advisers say they expect about 1,000 hedge funds will close in the next year (out of 6,000 in total) as investors withdraw money from losing funds. Tremont says that negative returns are not the only reason hedge funds close down; even mediocre returns may drive some funds to pack it in, as the fee income generated may not be enough to compensate fund managers

Perhaps this is just a scare story; after all, so far this year even after the losses, hedge funds in aggregate have substantially outperformed equity markets. Some strategies may have problems, but others dine out on falling equity markets. One candidate for the garbage dump may be convertible arbitrage: Reuters reports that hedge funds specialising in convertibles arbitrage are seeing outflows and several funds in London are in the process of liquidating positions. Some smaller funds may exit the market especially as fund of fund managers reallocate funds away from convertible arbitrage strategies. Some arbitrageurs are said to be turning to capital structure arbitrage and the credit swap default market.

It may or may not be rational to desert convertible arbitrage at this moment (Hennessee shows the class up 1.33% in September and 3.59% year to date), but investors are phased by the effect of equity falls on the market for convertibles. With issuance down and redemptions on the rise, the global convertible market is poised to contract over the next year, reducing choice. And most of the bonds in issue won't convert, cutting away the upside potential that is one of the main draws for arbitrageurs.

The end result of a hedge fund shake-out would presumably be a flight to quality. Forced liquidation of a hedge fund portfolio in the face of cash outflows is even more damaging than the equivalent process for a standard mutual fund, since many hedge fund plays rely on precise timing to achieve good results, and may be deeply out of the money most of the time. Thus, investors, especially the increasingly important fund of fund managers, may calculate that the safest place to be is with a large, liquid fund.

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