Hedge Funds Future: Time to 'Separate Men From Boys'

A once promising year for hedge funds has turned into another trudge through the muck, indicating that it may be time for the industry to rethink the way it does business.

New York Stock Exchange
Oliver Quillia for CNBC.com
New York Stock Exchange

Hedge fundreturns for the first half of 2011 have hovered around 1.3 percent, underperforming most other asset classes, including stocks and bonds.

That comes after a solid 4.8 percent gain in the first quarter — the best performance in six years — triggered hopes that the $2.1 trillion industry was recovering from an abysmal 2011 with losses in excess of 5 percent, according to Hedge Fund Research.

But with an explosion of worry about European debtand the accompanying unconventional intervention from central banks, hedge fund long-short and macro strategies have been blown apart.

Long-short involves buying assets that managers think will do well and short-selling those they think will fare poorly. Macro strategy involves using economic theory to buy global assets.

Both have faltered as the market has gyrated and policymakers have pulled out multiple plans to stem the damage.

"The industry is not doing well," says Anthony Scaramucci, founder of Skybridge Capital, which manages $6.3 billion for clients. "They have to create a version 2.0 of long-short strategies and version 2.0 of macro trading strategies that are building into their models more of this sort of activity."

For instance, Scaramucci says those betting against Spanish debtought to be holding winning hands considering the surging yields and precarious position the country holds as part of the European debt crisis epicenter.

But liquidity programs from European policymakers have clouded the environment in much the same way that U.S. authorities did in 2008 when the financial crisis here was entering a critical phase.

"Why the industry didn't do well last year and is not doing well this year is [that] 60 to 65 percent is in the long-short category or the macro category," Scaramucci says. "Long-short, in what is an obsessive governmental intervention environment, cannot do well."

Leaders in hedge funds and institutional investing gather Wednesday at the Pierre hotel in New York for the second-annual CNBC-Institutional Investor "Delivering Alpha" conference, where market leaders will discuss how to chart the difficult course ahead.

Not all hedge fund strategies are doing poorly, though high asset correlation — causing everything to move up and down together — is making positive returns all the more difficult.

Convertible arbitrage, which entails buying preferred shares while simultaneously short-selling the company's common stock and capturing the difference, gained 4.1 percent. The strategy is market-neutral — not dependent on whether stocks are up or down — and thus often considered a safer way to hedge.

"The market's going to have a pretty big correction downward over the next couple of months. Funds that are correlated to that are going to get slammed," says Uri Landesman, president of Platinum Partners, with about $780 million under management. "Since there's going to be a pickup at the end of the year, you run the risk of getting whipped and dipped."

"You're going to see some spectacular disasters from funds that are correlated and making big bets. It's important to be market-neutral," he adds.

Nevertheless, new-fund launches hit 304 in the first quarter, the most in more than four years, but 232 funds closed, a two-year high for liquidations, according to Hedge Fund Research.

Short-bias strategies, which contain a mix of long and short positions but with a net bet against the stock market, fared worst with a 7.1 percent loss, according to Bank of America Merrill Lynch data.

"The market's going to have a pretty big correction downward over the next couple of months. Funds that correlated to that are going to get slammed." -President, Platinum Partners, Uri Ladesman

Meanwhile, even with all the geopolitical turmoil, the S&P 500 gained 8.3 percent in the first half, making the short play a losing strategy.

"Throughout the second quarter, the magnitude of the uncertainty associated with this situation is making it very difficult for fundamentally based strategies to monetize the different opportunities across various hedge fund strategies," says Kenneth Heinz, president of Hedge Fund Research.

Despite the variables involved with the economies of Europe and the U.S., Heinz remains hopeful.

"In the second half of the year we will get resolution sooner rather than later where this is going to go," he says. "That will allow fund managers to get back to thinking about these fundamental questions rather than the broader, amorphous economic considerations."

Heinz sees "a crucial inflection point" for the industry and expects "higher returns in the second half of the year," while Scaramucci forecasts the industry's assets to triple in the next 10 years to more than $6 trillion.

"You really have to be honest about your hedging," adds Landesman, who says his fund gained 6.5 percent in the first half. "I'm optimistic about the players who are really generating alpha. What I like about it is I think we're going to really separate the men from the boys, and that's great for us."