Awful Summer May Not Mean Big September Redemptions

By Emma Trincal, Senior Financial Correspondent

NEW YORK (HedgeWorld.com) – Following a difficult summer for hedge fund performance, and with the credit crisis continuing to expand, many have predicted massive fund redemptions at the end of September, simply because the combination of bad performance and the end of a quarter offers skittish investors the justification and the window of opportunity they need when they want out.

“Based on recent fund performance, I would not be surprised to see funds of funds making portfolio adjustments and reducing exposure to those sectors perceived to be at greatest risk in the current environment,” said Sol Wakson, president of Barclay Hedge Ltd., a Fairfield, Iowa-based research and database provider, in an email.

Looking back, this was a gloomy summer for hedge funds. They were accused of triggering a credit crisis, which popped onto the public’s radar in a big way with the default of two Bear Stearns hedge funds in June. In reality, though, the double bursting of the housing and credit bubbles caused the crisis; the collapse of the Bear Stearns funds was merely the most visible sign to date.

Over the past several months, hedge funds have been the subject of negative headlines. They have also suffered further losses, which led to more blowups. In July, for instance, Sowood Capital Management, a well-respected fund managed by former Harvard Management Co. portfolio manager Jeffrey Larson, shut down due to credit losses. Some of the best and brightest quantitative managers experienced severe losses in the early days of August.

No wonder hedge funds’ performance in August was negative.

Yet with the market stabilizing a bit and some funds recovering from their prior wounds, it remains unclear whether September will be the bloodbath that many doomsayers predicted.

Earlier this month, Barclay Hedge and TrimTabs Investment Research reported that funds of funds redeemed a net $32 billion from hedge funds in July, the largest outflow since 2000. Conrad Gann, managing partner at TrimTabs, said that his firm currently is working on an update for this number, but he declined to say whether the new figure would show a brighter outlook, saying that it was too soon to tell.

August was a tough month for some of the largest and best- performing managers worldwide, hence the pessimism. After all, if even the best managers lose money, why would hedge fund investors remain confident?

Examples of such misfortunes among elite managers abound. The most recent case is Old Lane, the hedge fund founded by Vikram Pandit in April and now part of Citigroup. Old Lane posted a 5.9% loss in August, according to a person familiar with the situation. Bruce Kovner’s Caxton Associates LLC, with $10.55 billion in assets, lost 4.76% last month and has posted a negative 1.47% return for the year. Paul Tudor Jones of Greenwich, Conn.-based Tudor Investment Corp. saw his Tudor B.V.I Global Fund Ltd., a $5.6 billion diversified global fund, lose 5.51% in August, trimming the yearly return to negative 1.53%. Several of Louis Bacon’s Moore Capital Management LLC funds were negative last month, including the Moore Emerging Market Fund Ltd. and the Moore Global Fixed-Income Fund Ltd., which posted respective losses of 8% and 4.25%.

Looking at the performance benchmarks, the August picture as a whole is negative, but not as catastrophic as expected. The Hennessee Hedge Fund Index was down 0.72% for the month, its worst performance for the year. Hedge Fund Research Inc. said that its HFRI Weighted Composite Index posted a 1.31% loss for August, with emerging markets, high-yield and macro strategies turning in the worst performance.

“Hedge fund performance volatility increased at the end of July and has persisted into September, driven in part by investor concern about continued deterioration in the subprime mortgage sector and the corresponding impact on access to liquidity by both consumers and corporations,” said Kenneth Heinz, president of HFR, in a statement. “While a number of strategies posted losses for the month, much of these aggregate, intra-month losses were pared into month-end.”

And that’s precisely why it’s not certain that investors will be redeeming en masse at the end of September. For some, August may have just been a hiccup and the important lesson here will turn out to be that the pros were able to rebound and recover in a fairly quick fashion. After all, hedge funds are not immune from losses. But their function is to limit the losses and to do it fast.

Quantitative hedge funds are the best examples.

“Performance of quantitative funds is typically influenced by model-driven factors including the persistence of investor behavior and the mean reverting characteristics of the relationships between securities – both long and short – to their historical or predicted levels,” said Mr. Heinz. “Disruption of these can negatively impact performance but to the extent that those relationships are re- established, performance can also recover.”

Which turns out to be what happened; most quant machines worked out after all.

While Renaissance Technologies Corp. suffered major losses and bad publicity in the first part of August, its founder Jim Simons managed to weather the storm as the firm’s flagship Renaissance Institutional Equities Fund ended the month with little change.

The same is true of AQR Capital Management LLC, which endured losses in the early part of August but managed to both recover most of the negative performance and attract positive net capital inflows during the month.

“My sense is that investors will stand pat and perhaps reverse some of their redemption requests once they believe hedge funds have stabilized,” said Jaeson Dubrovay, who heads the hedge fund practice at New England Pension Consultants in Cambridge, Mass.

While hedge funds are expected to deliver returns uncorrelated with standard market indexes, there are times during market swings or liquidity shocks when they will post losses. Sophisticated investors have seen such volatility before and are prepared to see it happen from time to time.

“From what we see of August performance so far, many funds are down between 1% and 2% for the month, but are positive on a year-to- date basis. Our clients, who take a long-term approach to hedge funds, are fully aware of what to expect and the last couple of months’ returns are well within expectations,” Mr. Dubrovay said.

On a yearly basis, funds that have lost money in August are still up for the year. For instance, the Moore Emerging Market Fund Ltd. and the Moore Global Fixed-Income Fund Ltd. were up year-to-date 17% and 6.22%, respectively, through the end of August.

This is also true of the benchmarks. As of the end of last month, all six strategies tracked by the Dow Jones Hedge Fund Indexes were up year-to-date.

Based on this and other evidence, most analysts said they can’t predict massive hedge fund redemptions next month.

“It is difficult to tell at this point because of operational and timing considerations at the fund of hedge funds themselves. Based on what I have seen so far, there has not been a rush to the exits – rather investors are analyzing their portfolios to ensure that their initial thesis for investment in specific funds remains intact,” said Mr. Dubrovay.

Redemptions, if they occur in significant amounts, are sure to be painful for funds of funds. But the pain may be felt most by smaller funds of funds with a concentrated client base.

Mr. Dubrovay said larger funds of funds may have an advantage over the smaller ones in that their client base may be more diverse; they may have implemented gates and they may insist that investors adhere to a longer lock-up period in order to better match the liquidity schedules of their underlying managers.

“Smaller funds of funds have a higher probability of ending up with a mismatch between the liquidity they offer their investors and the liquidity of their underlying funds due to their lumpy allocations to fewer managers,” he said.

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