Pruning Season

Nissim Tse is ready for a fight. For the past five months, Tse, head of trading in Hong Kong for hedge fund RAB Capital, has been torturing his body in preparation for a charity boxing match against some of the city's other hedge-fund managers. The training is bruising, but Tse is happy to participate. After all, the pounding he takes in the ring isn't as dispiriting as the one he has been enduring at work lately. "Going into the office every day is like walking on land mines," Tse says. "This is going to be the worst crisis in my lifetime."

All over the world, hedgies like Tse are taking it on the chin, victims of the global financial crisis and the one-two punch of poor returns and unhappy investors. After nearly doubling in size since 2002, to around 8,000 total funds last year, the industry is on the brink of a brutal contraction as customers — rich investors, university endowments and pensions funds that make up the bulk of hedge funds' clientele — rush to withdraw their investments. Some analysts predict that a quarter of all hedge funds could fold by the end of the year. Stephen Brown, an economist at New York University's Stern School of Business, says the final toll could be much higher. "I'd say 50% of funds will close," he says. Factor in likely new government regulation, and the industry looks set for a profound, and painful, transformation. One newly retired fund manager seemed to sum up the current mood when he recently told the Wall Street Journal: "What I've learned about the hedge-fund business is that I hate it."

Increasingly, so do investors, who are losing faith in hedge funds as a safe place to park their wealth during times of economic turmoil. Funds flourished earlier this decade by offering higher returns than investors could get in more conventional vehicles. Because they are largely unregulated, managers are free to employ a wide variety of sophisticated strategies, including short-selling (borrowing a stock and selling it in the hope of buying it later at a lower price to return to the original lender). The objective is to achieve — for hefty fees — consistent positive returns in good and bad markets, and at reduced risk. But the crash in global equity markets has dented fund performance and fractured investor confidence. In September alone, $43 billion fled the $1.7 trillion industry, according to TrimTabs Investment Research. "Hedge-fund investors are losing so much money elsewhere, they're shooting first and asking questions later," says Robert Howe, a fund manager in Hong Kong.

Hedge funds as a class are still doing better than broad market indexes — or, rather, they have been performing less badly. The average hedge fund is down about 20% in 2008, according to Hedge Fund Research's HFRX global index. By contrast, the Dow has dropped 40% this year; MSCI's index of developed and emerging stock markets has plunged nearly 50%. But some large, established funds have taken big hits. In mid-October, the $17 billion Chicago-based firm Citadel Investment told investors that its flagship fund had dropped nearly 30% this year. According to Singapore-based Eurekahedge, which tracks the industry, hedge funds lost an average of 4.7% in September, the worst monthly performance since the company began collecting data in 2000.

Managers are getting squeezed on all sides. As investors pull out, hedge funds are being forced to raise cash to meet redemptions by liquidating their holdings. In addition, highly leveraged funds are being forced by their bankers to come up with more collateral as the value of their holdings falls, forcing managers to sell more shares to raise more cash. It's a vicious circle: funds are rushing to sell the same illiquid securities, driving stock prices down and triggering new waves of selling. This mass deleveraging by the industry has been cited as one of the causes of recent record volatility in world markets.

Little wonder many investors are rushing for the exits. But there were signs of trouble even before the onset of the bear market. Earlier this year, Spectrem Group, a Chicago-based consultancy that tracks the habits of Americans worth between $5 million and $25 million, reported that the wealthy were dropping hedge funds from their portfolios. In 2005, Spectrem said, 38% of high-net-worth individuals invested in the funds; by 2007, the proportion had fallen to 7%.

Hedge funds restrict themselves to extremely wealthy investors who understand the risks involved and who can hypothetically absorb occasional big losses. In return, the industry has largely been exempted from the regulatory and disclosure requirements imposed on more common mutual funds. But hedge funds haven't just been the domain of the ultra-rich. Other pools of wealth, including university endowments and public pension funds, have put their money in so-called funds of hedge funds, which spread risk by investing in a portfolio of hedge funds and hence are considered safer. But since hedge funds are doing badly, so are funds of hedge funds, which appear to be headed for their worst year ever. On Nov. 6, shares in London-based Man Group, the world's largest publicly traded fund manager, fell 31% on news that its Man Global Strategies fund of funds had lost more than 20% of its value so far this year.