First, the money rushed into hedge funds. Now, some fear, it could rush out.
Even as Washington reached a tentative agreement on Sunday over what may become the largest financial bailout in American history, new worries were building inside the nearly $2 trillion world of hedge funds. After years of explosive growth, losses are mounting — and so are concerns that some investors will head for the exits.
No one expects a wholesale flight from hedge funds. But even a modest outflow could reverberate through the financial markets. To pay back investors, some funds may be forced to dump investments at a time when the markets are already shaky.
The big worry is that a spate of hurried sales could unleash a vicious circle within the hedge fund industry, with the sales leading to more losses, and those losses leading to more withdrawals, and so on. A big test will come on Tuesday, when many funds are scheduled to accept withdrawal requests for the end of the year.
“Everybody’s watching for redemptions,” said James McKee, director of hedge fund research at Callan Associates, a consulting firm in San Francisco. “And there could be a cascading effect, where redemptions cause other redemptions.”
What happens at hedge funds, those loosely regulated private investment vehicles, matters to just about every investor in America. Hedge funds are not just for the rich anymore. Since 2002, the industry has roughly tripled in size, as pension funds, endowments and foundations piled in, hoping for market-beating returns.
Now, the heady returns of the industry’s glory days are over, at least for now. This is shaping up to be the industry’s worst year on record, with the average fund down nearly 10 percent so far, according to Hedge Fund Research. Famous traders like Steven A. Cohen, who runs SAC Capital Advisors, are losing money, and even Kenneth C. Griffin, the head of Citadel Investment Group, is down in one of his funds.
And they are the lucky ones. A growing number of hedge funds are closing down. About 350 were liquidated in the first half of the year. While hedge funds come and go all the time, if the trend continues, the number of closures would be up 24 percent this year from 2007.
Many funds are bracing for trouble. The industry has set aside $600 billion in cash, according to Citigroup analysts, partly because of the uncertainty hanging over the markets but also because of possible redemptions. If redemptions do pour in, hedge funds can freeze the process by not paying investors for a certain period of time, slowing the pace of withdrawals.
One little-known hedge fund barometer is pointing to trouble, however. The alphabet soup of complex investments that Wall Street created in recent years — R.M.B.S.’s, C.D.O.’s and the like — includes C.F.O.’s, short for collateralized fund obligations. Virtually unknown outside the industry, these investments are the hedge fund equivalent of mortgage-backed securities: securities backed by hedge funds.
But last week, credit ratings agencies warned that they might lower the ratings of several C.F.O.’s, in part because of the concern that investors would withdraw money from the funds backing the investments. Standard & Poor’s downgraded parts of nine C.F.O. deals, Fitch placed five on a negative rating watch, and Moody’s put one on a downgrade review.
“The concern is over the redemptions that are happening,” said Jenny Story, an analyst with Fitch Ratings. “The gates are being closed.”
While few in number, C.F.O.’s represent a broad swath of the industry. The vehicles were created by funds of funds, which invest in hedge funds. Each C.F.O. includes stakes in dozens and sometimes hundreds of hedge funds with a variety of investment strategies.
Coast Asset Management, a $5.6 billion fund of funds in Santa Monica, Calif., created three C.F.O.’s in the last few years. The three vehicles raised a total of $1.85 billion, according to Dealogic, and they have a seven-year lock-up on the money. It was that lock-up that appealed to David E. Smith, the firm’s chief executive, who ran into trouble borrowing in 1998, after the collapse of the giant hedge fund Long Term Capital Management.
Coast executives said they were not particularly concerned about the C.F.O.’s, because they had not seen many hedge funds putting limits on redemptions, or “closing the gates,” as the industry calls it.
“It’s clearly been a very tough year for investors in general,” Mr. Smith said. “But I think hedge funds have done a good job of navigating very tough markets and don’t get the type of recognition that they should.”
Two of the C.F.O.’s put on watch or downgraded by the ratings agencies are run by two units of the British hedge fund Man Group. One is run by Glenwood Capital in Chicago, which saw its multi-strategy fund lose more than 4 percent through July, according to an investor. A spokesman for the funds declined to comment.
Returns are not in yet for September, but hedge fund managers say this month is even worse than the summer. Some funds were hurt by new rules from the Securities and Exchange Commission on short-selling, a tactic for betting against stock prices. The commission made it more difficult to short all stocks and temporarily banned the strategy in more than 800 financial stocks. In particular, this hurt convertible-bond managers, who often buy bonds that can be converted into shares and short the underlying stocks.
The short-selling ban lasts until Thursday evening, but it is widely expected to be extended.
John P. Rigas, the chief executive of Sciens Capital Management, knows firsthand how difficult it can be to get money out of troubled hedge funds. He spotted problems at Amaranth Advisors a year before that fund collapsed because of wrong-way bets in the energy markets, but it took him eight months to retrieve all of his fund of funds’ investment. Mr. Rigas’ firm runs a C.F.O. that is invested in 41 hedge funds, but he said he had put more than 25 percent of his funds’ capital into cash to weather the storm.
He predicts further liquidations in the industry.
“How can I say that the environment is not bad?” Mr. Rigas said. “It’s difficult with hedge funds because they are very fragile. By their nature they’re fragile instruments because investors can ask for their money.”