Based on the billions that poured in last month, the hedge fund industry appears to have its swagger back. Investors are lining up to put their trust in mysterious firms notorious for market manipulation that give Wall Street a bad name. But the industry’s resurgence from the financial crisis has just a few big winners and analysts expect a hedge fund shakeout in 2011.
Hedge funds treading water
The hedge fund industry attracted $22 billion from investors in March, the highest rate in over a year, according to Hedgefund.net. Overall, the hedge fund industry is managing $2.5 trillion, 83 percent of the all time highs registered in 2008. But aside from a few superstars, hundreds of hedge funds are scrambling to reach their historic peaks, the point at which they can resume collecting profits. In fact, Hedgefund.net reports that about 35 percent of 2,500 funds that voluntarily report performance have yet to return to their high water marks. While investors are seeing returns, the hedge funds themselves can’t charge performance fees until the assets they manage return to their pre-financial crisis peak. For example, a hedge fund managing $100 million that lost 25 percent during the meltdown must generate returns of up to 35 percent on the remaining $75 million to hit the high water mark. It could take years before the fund resumes collecting 20 percent on investment returns.
Hedge fund market manipulation
Established hedge funds with billions in assets struggling to reach their high water marks keep the lights on with management fees–about 2 percent of those assets, and charge clients for expenses. Others who lost most of their client’s money simply shut down, reopen under a different name, entice new investors and start collecting performance fees. Then its business as usual, which includes classic forms of hedge fund market manipulation. For hedge funds that have returned to performance fee territory, most of them inflate reported returns by buying up their own holdings the last few seconds before a quarter ends. After their fabricated results are recorded, they dump the stock. A study conducted by analysts from Ohio State, Swiss Finance Institute, Toulouse School of Economics and Wharton confirms this practice. The research found evidence that shows stocks with a high percentage of hedge fund ownership benefit from startling last-second rallies more often than would be considered normal. After the manipulation, stocks with high hedge fund ownership also trended toward lower returns on the first day of the month.
The hedge fund mystique
With so many hedge funds struggling to make a comeback, industry experts predict a hedge fund shake-out in 2011 as underperforming funds lose top traders to rivals and disappear from the landscape. Statistics show this is already happening all the time. According to Hedgefund.net, the median return of 1,400 hedge funds tracked over the past five years is 41 percent. But during that time, 3,000 hedge funds fell by the wayside. According to Brett Arends at MarketWatch, the great numbers reported by the hedge fund industry only include a few of the survivors. He conducted his own 10-year comparison with a “vanilla portfolio” and 2,229 hedge funds that started in 2001. The vanilla portfolio gained 94 percent. The hedge funds that failed (75 percent) would have had to gain 60 percent for the industry as a whole to match the vanilla portfolio. One fifth of the 535 survivors didn’t come close.