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By Knight Kiplinger

The Kiplinger Washington Editors

July 2, 2009

By year-end or so, Congress will give the nod to a major rewriting of the nation's financial regulatory system. This week’s Kiplinger Letter explores whether the package will do more harm than good and what lawmakers are likely to include.

ALSO IN THIS ISSUE: The Economy, Business Costs, Taxes, Supreme Court, Energy, Workplace Regulations, Climate Change, Health Care Legislation and Foreign Policy

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Hedge Funds Pay a Price for Market Meltdown

Up to 20% of industry players will shutter their doors in the next two years.

By Renuka Rayasam, Associate Editor, The Kiplinger Letter

October 8, 2008

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As many as 500 hedge funds may be forced to shut down by year-end, and 1,000 more will go under in 2009. It’ll be the first thinning of their ranks since the $2-trillion unregulated industry started keeping records in 1990.

Chaos on Wall Street, combined with a temporary ban on short selling, will make for the roughest two years in almost two decades for hedge fund investors, who have seen hefty profits evaporate amid the financial market meltdown.

Funds are now confronting the annual redemption process, which began on Sept. 30, and investors are demanding their money back from underperforming funds. Adding to fund managers’ woes is the Securities and Exchange Commission’s decision to extend a temporary ban on short selling until midnight on Oct. 8.

Betting that a stock price will decline is one strategy many hedge fund managers had used until now to ride out stock market lows. With that option off the table, jaw-dropping losses can’t be concealed.

Hedge funds undoubtedly will be more regulated in the future. “The industry will have to evolve to survive whatever policy agenda gets handed to them,” says Ken Heinz, president of consulting firm Hedge Fund Research Inc.

Short selling wouldn’t have been banned forever. It’s too important to the healthy functioning of capital markets. But the SEC will impose more requirements, such as forcing funds to disclose more information, as is required in the United Kingdom. And the SEC has already launched investigations into some fund activities. “It’s certain that there will be major involvement by the federal government in this Wild West-style market,” says Pat McGurn, senior vice president and special counsel at RiskMetrics consulting firm.

Hedge funds swelled during boom times, taking big stakes in underperforming companies and buying up billions of dollars of complex securities and exotic derivatives. Fund managers routinely gave their investors eye-popping double-digit annual returns, but their strategies fell victim to the seizing up of the credit markets, when banks and other investors were unwilling to buy or sell billions of dollars of securities backed by faulty mortgages.

So far this year, hedge fund performance as a group is down 4%, not bad compared with the Dow Jones Industrial Average’s 25% drop. But that’ll be small consolation to the hedge fund players who have never experienced a down year.

In the first half of the year, 350 hedge funds went under, compared with 563 in 2007, according to Hedge Fund Research. Heinz thinks that up to 20% of the industry’s 10,200 funds may shut down within two years.

“There is going to be a shakeout” in the industry, says McGurn. Yet he and others point out that the savviest players will capitalize on the industry’s woes.

The shuttering will ripple through the economy, creating more volatility in the stock market and drying up another source of funding for businesses. The effects don’t stop there. Around 21% to 27% of pension plans invest in hedge funds, according to a Government Accountability Office report. Endowment funds and other market players, lured by high returns, also invest in hedge funds.

In the past year, the top 10% of funds outperformed the bottom 10% by more than 75% -- the widest spread on record, according to Hedge Fund Research. “The top tier controls the lion’s share of investor dollars,” Heinz says.

That puts many of the top tier players in prime position as their competition thins. These include Citadel Investments and SAC Capital. And hedge funds had a record $156 billion of cash at the end of July, according to a Merrill Lynch report. Those that make it through the year in one piece will be able to pick up talent from failing funds while taking advantage of the deals from a Treasury plan and market upheaval.

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