Thursday, June 10, 2010

Hedge Funds Fail To Prevent Large Losses In May

While many, if not most, hedge funds don't actually "hedge", they do promote themselves as un-correlated to the market, thereby theoretically providing investors with less risk.  Unfortunately, their performance during market meltdowns demonstrates quite the opposite.

Nearly every market correction or bear market has been accompanied by overall poor returns and often complete wipe-outs of these believed-to-be elite vehicles.  Is this asking too much?  Possibly, but since most funds charge premium fees, shouldn't investors expect premium performance?  Especially during the most volatile and difficult periods?

The month of May, which included a 1,000 point intra-day loss for the Dow Jones Industrial Average, was a perfect test case.  Volatility, which had been subdued for a year, suddenly exploded.  If there was any time for a hedge fund to strut its stuff, it was last month.  How'd they do?

Terribly!  May was the worst month for hedge funds since November 2008, according to Hedge Fund Research Inc. (HFR).  Virtually every strategy was down.  Larger funds managed by SAC Capital, Paulson & Co. and Third Point Management lost between 2.3% and 5.6% in the month, say people familiar with the funds. Their mistakes ranged from concentrated bets on consumer companies to financial-company wagers.

Louis Bacon, who founded Moore Global Investment, had scored annual gains of about 20% on average over the past two decades.  His largest fund endured losses of 9.2% in May, way underperforming the average decline of 2.3%, according to HFR's index.

The average hedge fund was up 1.3% for 2010 through May, compared with a 6.4% decline for the big Moore fund.

Eurekahedge, a Singapore-based fund tracker, publishes a series of indices on a monthly basis, measuring the returns of hedge funds by region and investment strategy.    Its indices showed hedge funds focusing on Asia (excluding Japan) lost an average of 4.86% during the month of May, pushing total returns for 2010 to minus 3.15%.

Barclay's index of hedge fund returns for May, which encompasses more than 1,300 funds, showed a loss of nearly 3%, nearly wiping out all returns for 2010.  The Credit Suisse/Tremont Index revealed a drop of 2.26%.

But money still poured into hedge funds for a second consecutive quarter, making the industry reach $1.66 trillion of assets under management, up from $1.60 trillion in the last quarter of last year, HFR reported.  The hedge fund industry reached a record $1.8 trillion under management at the peak of the market in 2007, but the figure is now lower following client withdrawals and the credit and equity losses suffered during the credit crunch.

While hedge funds advertise themselves as sophisticated investors, they are still prone to huge losses which can easily become complete wipe-outs.  This is the result of the use of massive leverage in combination with risky trades.  Since they make their compensation by taking a portion of gains, but don't always cough up money when they lose, hedge funds are incentivized to roll the dice.  Heads I win, tails you lose.

Everyone who still has assets in my fund, please step forward.  You, not so fast!

Of course, if they screw up, they are the first to accept responsibility (sarcasm intentional).  Goldman Sachs  (GS) was sued for $1 billion by Basis Yield Alpha Fund (Master), an Australian hedge fund, claiming that the bank made “misleading statements” in connection with Timberwolf, a complicated mortgage security the bank underwrote in 2007.

A spokesman for GS said: “The lawsuit is a misguided attempt by Basis, a hedge fund that was one of the world’s most experienced CDO investors, to shift its investment losses to Goldman Sachs."  Loathe as I am to agree with "Government Sachs", they have a point.  How does an entity claiming expertise in CDO's get taken advantage of to the tune of a total loss?  Goldman did NOT force them to over-leverage.

A spokesman for GS went further: “At the time of the Timberwolf transaction, Basis specifically stated that it would not place any reliance on Goldman Sachs.  Basis is now trying to recoup its losses based on false allegations that it was misled about aspects of the transaction and market conditions.”

Sorry Basis, you can't have it both ways.  You either know what you're doing, or you don't.  You can't claim to be an expert, sign a "big boy" letter attesting to that and then claim to have been duped.

Of course, if the trade had worked out for you, and GS lost money, you'd have no problem with the "misleading statements".  Or, would you give it back to Goldman?  Point made.

If you're invested in hedge funds, caveat emptor.  

Marko's Take

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