Hedge fund bloodletting should prompt contemplation

OUCH! Actually, that didn’t hurt so much. News that hedge funds suffered redemptions of $25.2 billion last month may translate into some individual shops closing, but for the industry as a whole, it’s a drop in the ocean.

The bad news is that this latest bloodletting won’t be a cure. Managers have a clouded future to contemplate.

For hedge funds worldwide, July was the worst month for redemptions since February 2009, according to an eVestment report. That followed net outflows of $23.5 billion in June, bringing the total to $55.9 billion so far this year. That’s a lot of cash, but look at it in the context of the $2.7 trillion managed by the industry, according to BarclayHedge data.

A reversal was only natural after the run of strong inflows to hedge funds since 2009. Nor is the leakage across the board. Commodity funds consistently attracted new money this year, bringing inflows to $10.3 billion over the last 14 months. Meanwhile, the most popular strategy, long-short, is also one of the worst hit, as Gadfly’s Michael Regan noted.

Those two facts seem to support the idea that the latest move is more of an adjustment than a final breath for the industry. The majority of redemptions happened among money-losing funds, and inflows were recorded for those that gained more than 7 per cent this year.

While fund managers may feel like bemoaning the fickleness of investors, they can’t be blamed. When you’re paying a fixed 2 per cent of your assets and 20 per cent of extraordinary gains (which often aren’t that extraordinary) as fees, it’s natural to move where the juice is apparent. That might be misguided, because today’s losers can be tomorrow’s winners — but at that level of costs, the urge for regular fat rewards is natural.

Unless the traditional fee equation of hedge funds is challenged, their business will remain cyclical: The winners taking in ever more money and the losers being denied the chance to reverse their bad fortune.

Then there’s the cruelty of the current environment. In a low-interest-rate world, traditional assets have everything going for them. Central banks have given a boost to long-duration investments, from real estate to private equity, Ben Inker, the co-head of asset allocation at Boston-based value shop GMO, said in a recent quarterly letter. The opposite is true for assets that are less sensitive to interest rates because of their shorterterm horizon, such as hedge funds.

This is the pernicious side of financial math, which evaluates everything on a discounted cash-flow basis. Even though the future expected payments of most of these long assets haven’t changed, as the discount rate drops their present value rises. The best way to make money these days is just to sit on an index. Most hedge fund strategies don’t work that way.

Given that the Fed, the European Central Bank and the Bank of Japan are nowhere near returning to a “normal” monetary policy, that issue will endure. In turn, that means more lackluster returns overall — there are always some managers that stand out — and more redemptions.

It will take dozens of bad months like July before the hedge-fund industry faces an existential threat. With the current run on assets unlikely to stop, however, this is an opportunity for managers to rethink their ways.