Year after year, the hedge fund industry dazzled Wall Street by delivering "absolute returns"—outsized profits whether markets rose or fell. Using sophisticated trading models, the pools of managed capital made wealthy people wealthier with eye-popping returns that carried seemingly moderate risk.
Not these days. Blind-sided by a colossal market collapse and the widening Bernard Madoff scandal, hedge funds suffered their worst showing on record last year. And they're bracing for more pain in 2009. The industry's fall proves that even the quantitative brilliance and market wizardry of elite hedge funds are no magic bullet for investors during brutal times.
"Hedge fund managers have always said, 'Look, we know how to make money even in difficult times,' and that turns out to be a fallacy," said Timothy Brog, portfolio manager of New York-based hedge fund Locksmith Capital Management.
Nearly 700 funds—7 percent of the industry—shut down in the first three quarters of 2008, up over 70 percent from the same period the previous year, according to Hedge Fund Research, a Chicago-based data firm. At that rate, roughly one in 10 hedge funds will have disappeared last year when final numbers are released in coming weeks.
Thousands more are expected to die in 2009 as investors who have been clobbered by losses yank out what's left of their money. Those investor redemptions have forced many hedge funds to liquidate large chunks of their assets, triggering "dramatic" swings in the stock market late last year, Brog said.
"Even if hedge funds make up only 10 percent of the market, it's going to have a big effect if they sell all at once," he said.
Besides the financial crisis and massive losses from Madoff's alleged pyramid scheme, self-inflicted wounds also haunted hedge funds, experts say. The funds' high-octane investment philosophy, they say, pushed many managers to make big bets with borrowed money despite the dangers.
"We grew into this culture of gunslingers," said Bill Fleckenstein, founder and president of Seattle-based hedge fund Fleckenstein Capital. For many hedge fund managers, the notion of managing risk through cautious trading was a "recipe for getting fired," he said. "All anyone really wanted was performance, and managing risk was a drag on performance," Fleckenstein said.
The average hedge fund lost 18 percent of its value in 2008, the industry's worst performance on record and down from an average gain of 9.96 percent in 2007, according to Hedge Fund Research. The only other negative year on record was in 2002. But even then, funds only lost an average of 1.45 percent.
Still, compared with the wider market, hedge funds don't look so bad. The Dow Jones industrial average lost 34 percent in 2008, while the Standard & Poor's 500 index fell 38 percent.
But hedge funds were never supposed to lose money.
The loosely regulated pools of capital burst onto the investment scene in 1990 with $39 billion in assets and quickly ballooned in numbers. Today, there are some 10,000 hedge funds, most of which cater to wealthy investors and promise big returns in virtually any economic climate.
Many hedge funds use complex models to trade crude oil and soybean futures, derivatives and other exotic assets out of reach to ordinary investors. Investors typically are charged a yearly fee equal to 2 percent of assets and 20 percent of profits. That fee structure has reaped eight- and even nine-figure paydays for the most successful portfolio managers.
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But not now. Hedge funds' assets hit an all-time peak of $1.93 trillion in June but have since fallen to $1.56 billion, according to Hedge Fund Research. The steep declines mean that most portfolio managers will be taking much smaller paydays in 2009.
Still, not every hedge fund lost money last year.
Chris Wang, founder and portfolio manager of New York-based SYW Capital Management, enjoyed a sizzling 2008 managing $52 million in assets. Using a strategy of "short-selling," or betting that stocks will fall, he managed a return of 80 percent. Wang, 36, said his fund "became ultra-bearish" once the scope of the credit crisis became clear.
"We could see the world coming to an end before our very eyes," Wang said.
Unnerved by losses, many hedge fund investors want their money back. Investors yanked $40 billion out of hedge funds in October, according to Hedge Fund Research.
Those who got their money out were the lucky ones. In recent weeks, dozens of hedge funds have imposed "gates" keeping investors from withdrawing their money, fearing a run on their assets that could drive them out of business.
As troubled funds throw up the gates, investors have little choice but to pull money from healthier funds, which then are forced to sell assets to raise cash.
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"It's disappointing," said Robert Romero, manager at Palo Alto, California-based Connective Capital, a $120 million hedge fund that delivered a 3.5 percent return in 2008. He said he expects to lose about 20 percent of his capital from redemptions.
Hedge fund investors are also grappling with the still unknown toll of Madoff's alleged pyramid scam, which authorities say bilked investors of billions of dollars. Among the largest victims were investors in "funds of funds"—capital pools that invested across a number of hedge funds, supposedly limiting risks.
Many funds of funds that were wiped out with Madoff have come under fire for not adequately vetting his trading strategy and for failing to diversify investors' assets. Several have written to frantic investors to reassure them that they're closely monitoring their investments, said Nadia Papagiannis, an analyst at Morningstar.
For many funds of funds, it's too late. There were 3,660 funds of funds listed in Morningstar's database at the end of 2008, a drop of about 12 percent from the previous year.
Fewer funds of funds mean fewer dollars flowing into traditional hedge funds. That will make it harder for many hedge funds to stay afloat in 2009. Barclays Capital strategist Robert McAdie has said that 70 to 80 percent of hedge funds could disappear this year.
Those that survive are likely to undergo sweeping changes, including lower fees charged to investors and a more back-to-basics investment philosophy that will lead to smaller annual returns.
But just because there will be fewer hedge funds and smaller rewards doesn't necessarily mean the high-stakes hedge fund culture will disappear, said Sol Waksman, president of Barclay Hedge Ltd., a Fairfield, Iowa-based research firm.
"Right now, fear is in the driver's seat," he said. "At some point, greed will return."