Wall Street Woes Spawn New Generation of Hedge Funds
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The Fiscal Times
January 20, 2012

The cost-cutting on Wall Street (particularly notable when it comes to initiatives aimed at limiting outsize bonuses) is about to spawn a brand new generation of hedge funds.

That is common sense. It has happened before in the wake of upheavals in global financial markets and the financial services industry. What is unclear this time is whether those next-generation hedgies will find investors quite as eager to back their new endeavors with cold hard cash.

Any trader who decamps after pocketing their 2011 bonus to set up a new venture is going to face a bit of an uphill battle. The average hedge fund lost 5.02 percent last year, according to Hedge Fund Research. A majority of existing hedge funds – nearly 60 percent of them, HFR announced Thursday – experienced outflows in 2011. Hedge funds employ a variety of strategies, but HFR reported that only one major category finished the year with average returns in the black. (That strategy is called relative value arbitrage, in which funds buy sell pairs of related assets, looking to take advantage of discrepancies in the pricing of those assets.) Still, despite a volatile year, the hedge fund industry as a whole managed to sneak across the $2 trillion threshold to close 2011 with $2.01 trillion in assets under management.

Nonetheless, some contrarians argue that hedge funds are one of the items on the new year’s “must own” list for investors, or at least for those affluent folks who have enough millions to spare to invest, or to put to work via a fund of funds. Smart traders, with flexibility when it comes to what they can own and what they can sell short, with the ability to use leverage (skilfully…) and manage risk should be able to outperform in anything approaching a normal investment environment, these pundits argue. “We believe that hedge funds continue to offer investors active management of exposures and risks, and expertise in navigating and profiting from market volatility,” proclaimed a recent memo from Citigroup’s private banking division. “Deep fundamental analysis” will once again emerge as vital in distinguishing stock and bond market winners from losers, the private bank argues.

Certainly, in a low-yield environment, the prospect of above-average returns from a nimble and savvy hedge fund manager is particularly alluring. And while pension funds – who make up a growing proportion of the hedge fund investment base – aren’t all that happy with the returns they earned (or failed to earn) from hedgies last year, they don’t see that many alternatives out there.

But anyone contemplating launching a new fund might want to consider those hefty outflow numbers, along with the fact that more than 200 hedge funds shut their doors in the third quarter of 2011. While that’s not a record, it’s a timely reminder that the hedge fund universe is a Darwinian one, where those who don’t prove their value quickly can bid farewell to dreams of becoming the next George Soros or Steve Cohen.

That said, small startup funds run by former star traders with great pedigrees might be among the best bets out there. The smaller a fund, the more nimble it can be; it’s hard for a behemoth fund to add value, since the number of stocks in which it can take a large enough stake to make a difference to returns is more limited. Pros who spend their working lives winnowing through the array of hedge funds out there – there are more of them, it seems, than Taco Bell outlets – say that a smaller fund that can venture beyond the world of ultra-liquid, ultra-efficient large cap stocks – where it can prove impossible to find an edge that will pay off – stands a better chance of beating an index.

On the other hand, any trader hoping that launching a new hedge fund is a ticket to immense personal wealth might want to hit the pause button. According to the 2012 Hedge Fund Compensation Report released last week, average cash compensation was expected to be a mere $311,000 last year, up very slightly from 2010, as the number of hedge funds posting double-digit gains was dwarfed by the by those expecting to report a loss.

The big risk that hedge finds, new and old and of any size, face is that 2012 will be another year when markets are not only erratic but highly correlated, making it difficult for them to gain any kind of edge. Investors may be prepared to overlook subpar returns for 2011, given the way that markets behaved, but a repetition of the 2011 results in 2012 likely won’t be viewed with as much understanding.

After all, the lure of hedge funds is the promise that they can successfully navigate even the most treacherous market conditions. That’s why investors fork over those hefty fees, from 1 percent to 2 percent of the capital plus 20 percent or more of the upside. At those prices, many investors can’t afford another bad year.

Business journalist Suzanne McGee spent more than 13 years at The Wall Street Journal before turning to freelance writing. Author of the book Chasing Goldman Sachs, she has written for Barron’s, The Financial Times, and Institutional Investor.