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Credibility Shaken, Hedge Funds Are Punished by Investors

Jesse Eisinger|The New York Times
Thursday, 17 Feb 2011 | 11:46 AM ET

Now for a bit of good news: Rationality may be breaking out in the hedge fund world.

Investors are punishing funds that have engaged in questionable behavior and balking at ever-escalating fees. Regulators are showing uncharacteristic backbone, insisting that they will not merely fight the last war when it comes to new rules.

That’s a big change from the old way of doing business in hedge fund land, which was to reward failure and ignore problems.

Think back to Long-Term Capital Management. The multibillion-dollar hedge fund imploded spectacularly in 1998, presaging much of the larger financial crisis a decade later. The fund’s implosion was caused by excessive leverage and gigantic derivatives positions.

The Federal Reserve Bank of New York engineered a Wall Street bailout and, in the immediate aftermath, regulators and investors professed a desire for change. Yet John W. Meriwether, the impresario who had blown up L.T.C.M., soon gathered billions in new assets — only to blow up again. Regulators watched passively as hedge funds grew meteorically without close monitoring.

Now after the financial collapse of 2007 to 2008, changes are dribbling in. It’s all the more surprising since hedge funds were not a cause of the crisis. Banks, especially Wall Street firms, get the credit for that. Plenty of hedge funds went out of business, but almost none of them were systemically important enough to stoke fears of a wider panic.

Nevertheless, the changes are welcome.

One hopeful sign is that institutions like pension funds and foundations are pulling money from hedge funds that acted cavalierly during and after the crisis.

Funds that had spectacular returns only to crash during the crisis, like Atticus Capital, have wound up their operations. At Harbinger Capital, the founder lent himself money from the fund, and investors have punished him for it. Shumway Capital tried to change its management structure without giving investors adequate notice, and now it is closing. Funds that have been ensnared in the insider trading investigation, fairly or not, are shutting their doors.

When liquidity dried up at the height of the crisis, certain funds prevented investors from taking money out of their firms. Now, some are suffering large-scale redemptions.

D.E. Shaw, the gigantic hedge fund complex, lost investors throughout last year even though it invoked triggers on terms agreed in advance. Other funds engaged in the more controversial practice of suspending redemptions without a previous contractual agreement. Investors have reacted bitterly to both kinds of suspensions.

Another sign of the new rationality is that hedge fund fees are finally creeping downward, a trend long predicted that had not ever managed to arrive.

In the past, hedge funds have been something of a “Giffen good” — that unusual market phenomena of demand rising as the price climbs. The more the hedge funds charged and the more exclusive they were, the more they were desired. Incentive fees, however, have finally begun to ebb, down to 19 percent from 19.3 percent three years ago, according to Hedge Fund Research.

D.E. Shaw is lowering the management fee on its Composite Fund to 2.5 percent from 3 percent and dropping its performance fee to 25 percent from 30 percent. D.E. Shaw declined to comment on the changes and, with about $19 billion under management, something tells me the firm will manage to scrape by, even with lower rates.

Still, fees ought to come down — the performance hasn’t been there.

Sure, there are examples of funds with spectacular returns, like Daniel S. Loeb’s Third Point, which had a 34 percent gain last year. Over all, however, performance lagged the stock market. Both the Hedge Fund Research composite index and its index of equity-based hedge funds trailed the Standard & Poor’s 500-stock index’s total return two years running.

Hedge fund managers justifiably argue that investors shouldn’t expect funds to beat the market every year. A well-managed hedge fund is devised to make money in good markets and bad, with less volatile returns.

But since many hedge funds lost spectacular sums in 2008, their credibility has been shaken. It turned out they weren’t hedging enough and were more correlated to the markets than they should have been. Investors weren’t getting what they were paying for.

We’ll see how long these positive developments last. Investors put almost $150 billion into hedge funds in the fourth quarter, a record, according to Hedge Fund Research. Assets now stand at $1.9 trillion, just below the peak reached before the financial crisis.

Still, funds that aim for slow-and-steady returns appear to be thriving amid the new risk-averse mood.

And as money rushes back to the industry, regulators seem poised to impose the first genuine controls on it. Hedge funds will have to register and disclose more about their activities to financial overseers.

Last week, the Federal Reserve issued its definitions of what a “significant nonbank financial institution” will be, drawing the lines broadly enough to include big hedge funds. The Fed, properly, has judged institutions’ significance based, in part, on how interconnected they are: how many trades they do, how many counterparties they have, how much they have borrowed. It’s a good, and necessary, step toward policing systemic risk in the system.

Just because hedge funds didn’t cause the last crisis doesn’t mean they can’t cause the next one.