Where to now for hedge fund industry?

WHAT is now developing into a once-in-a-lifetime economic crisis began as a financial crisis.

It was built over many years as we progressively became desensitised to risk in pursuit of greater wealth. Some of this was simply personal greed and some of it the political imperative to manufacture financial success as a way of empowering all.

The personal greed radiating from Wall Street became viral and swept around the world as chief executives persuaded boards that record profits were more to do with their sublime stewardship than the strong economic fundamentals that prevailed.

Governments, particularly in the US and the UK, believed we had entered a new economic era in which they could legislate to ease credit standards and get the poorer of society into housing - the source of social stability.

For a time it was a virtuous cycle. However, in its final stages, mortgage originators lost all moral perspective, credit rating agencies modelled their ratings on bull market metrics, Wall Street and their service providers had their snouts deep in the trough, and investors completely lost their commonsense understanding of business cycles.

Then the music stopped.

Fundamentals changed. Over-leveraged and unqualified investors and homeowners were forced to sell; mark-to-mark accounting, regulatory mismanagement, forced deleveraging ... asset values spiralled down.

Things went so bad so fast that financial markets suffered 'cardiac arrest' on September 15 last year, leaving governments no option but to go 'nuclear' with measures such as guaranteeing bank deposits, nationalising banks, globally coordinating interest rate cuts, directly purchasing commercial paper, and ballooning the monetary base with the US Federal Reserve selling dollars to whoever needed them.

However, rather than stem the turmoil and bolster confidence, confidence became another victim of impairment.

So where to in 2009?

This crisis has legs; it has permeated the balance sheets of even the steady ships such as insurance companies and superannuation funds. Asset valuations are at extraordinary prices, market volatility remains high and liquidity is only dripping back into business.

Successful investors will start buying counterintuitive investments from now on, including corporate debt (bonds and loans), mortgages (residential and commercial), convertible bonds, long/short equity portfolios and distressed debt and deep value equities.

Implicit in my company's modelling going forward is that credit (bonds) is much cheaper than equities. In fact, equities would need to fall a further 20 to 30 per cent to offer similar value to many credit products. As well, forced selling continues and volatility is reflected in part by significant declines in broker/dealer capital devoted to market making.

UK-based hedge fund research and database group, Barclay Hedge, reports that the majority of its hedge fund indices were positive in January.

Overall, Barclay reports that hedge funds effectively broke even for the month. Against that, the US S&P 500 lost more than 8 per cent in January, while our own All Ordinaries fell more than 3 per cent.

It is estimated that the number of hedge fund managers grew from 4,000 to 10,000 during the past decade, spawned by the industry's out-performance during the 2000 to 2002 bear market.

By the middle of last year, they controlled almost $US2 trillion in capital. However, when the leverage of some hedge fund strategies was factored in, that figure rose to $US5 trillion - and now, in retrospect, the consequences of the industry's dramatic growth becomes evident.

Hedge funds had shifted from their historic position as nimble operators on the edge of the market to, collectively, in effect become the market - at least in certain securities. Hence, they were trapped inside as the market collapsed in the fourth quarter of 2008.

Market forces have now corrected the imbalance and hedge fund assets and market positions are back at 2001 levels with about $US1 trillion invested. Leverage - the source of so much selling - has gone.

Gone, too, are many hedge funds. In their flight to safety, investors indiscriminately redeemed what they could regardless of strategy, size or performance. More funds will close. Concurrent with the reduction in assets and managers, though, are increased opportunities for the remaining hedge fund managers.

The best example of this in distressed debt, estimated at more than $US1 trillion in size and growing. Mark-to-mark accounting, evaporating liquidity and scarce capital make for compelling opportunities in this area. In many instances 'true' AAA debt instruments are trading at distressed levels more reflective of financial Armageddon than reality.

As the president of Hedge Funds Research Inc, Kenneth J Heinz, observed recently: "The hedge fund industry has returned an average of 11.8 per cent annually since 1990, and an average 15.9 per cent in the 12 months following the five largest historical declines. While we expect continued asset consolidation, the combination of improving credit markets combined with an unprecedented level of global financial stimulus, are likely to be supportive of industry performance in 2009."

So, is the industry about to return to its historical self, inhabited by a comparatively small group of talented money managers operating on the fringes of the market and generating outsized returns for sophisticated investors? While past performance is no guarantee, the likelihood is high.

n Jon Horton is managing partner of NWQ Capital Management, a fund of hedge funds operator based in Perth.