Hedge funds may very well be described as the most mysterious and secretive part of the financial world. Unregulated, highly competitive and characterized by large rewards, they attract only investors with large appetite for risk. However, nowadays it is a rough time to be a hedge fund. As if huge losses were not enough, these financial institutions may soon face the threatening scrutiny of regulators.
2015 was not a good year for hedge funds. 979 of them were forced to close down their operations amid bad bets and investments. Many funds have returned the capital to investors and have become family offices, managing their own money. Poor investment performance is considered the main reason for this situation. A lot of hedge funds have invested in potential mergers that resulted to be failures, like the Allergan-Valeant deal, and in the energy sector, which is still suffering from low prices.
Dan Loeb, founder of Third Point, defined the current state of hedge funds as a “washout”. He believes that this is because of the catastrophic performance during the last year. Furthermore, Mr. Loeb added that this is only the first wave and the growing complexity in markets is here to linger. Bloomberg reports that hedge funds lost 1.9% in the first quarter of 2016, the poorest performance since 2008. The net outflows in the last two quarters are valued to be $16.6 billion, the highest since 2009.
Senfina is Blackstone’s top hedge fund unit and was created in 2014 as a multi-strategy business within the hedge fund. Its main purpose was to provide additional capacity and diversification to clients. However, even the crown jewel of Blackstone could not manage to avoid the losses crippling the sector. It has fallen 15% in the last three months, mainly during the turbulent period of January and February. Even though its returns were 20% last year, this quarter it has performed worse than most of its rivals. This has caused many market participants to doubt the multi-strategy of funds. The objective of these is to engage in a variety of investment strategies, thus ensuring lower risks than equity market investments.
John Paulson, one of the geniuses of the hedge fund industry, has not fared well too, recently. He is well known for betting against the subprime mortgages in 2007, which resulted in 158.5% and 37.6% gains in 2007 and 2008 respectively. Mr. Paulson has mainly focused on pharmaceutical companies, most notably his (losing) bet on the Allergan and Valeant merger that ultimately caused a $2 billion loss in his fund’s assets. His hedge fund, Advantage Plus, has decreased 15% this year.
The chaotic and turbulent situation at the start of this year managed to affect even the most prominent and diversified hedge funds, as the three examples show. However, wrong investments in ill-fated deals and lower commodity and energy prices are only part of the reasons for the recent troubles. Most of the hedge funds cut their bullish bets and moved towards shorting their positions believing a worse crisis was ahead. This proved to be hasty as the market reversed its course and has been performing quite well, even regaining some of its losses from February.
The Financial Stability Oversight Council said last week that they are turning their attention away from banks and towards hedge funds. These funds provide limited information to outsiders, so assessing their riskiness is very difficult. The Fed and Treasury want, therefore, to increase scrutiny in the attempt of keeping a closer eye at these institutions which use a lot of leverage in their daily activities. The US Treasury Secretary, Jack Lew, confirmed that the amount of leverage in hedge funds does not look high, however it is concentrated mainly in the large funds. The main worry from the hedge funds is that this may be the first attempt at more tight and strict regulations. As one representative of this sector said, if a fight breaks out in a bar, you take a swing at the guy you have always wanted to hit, regardless whether he had anything to do with the fight, implying the desire of the government to deal with the untouchable hedge funds.
The doom of the hedge fund industry has been predicted for decades now. Nevertheless, this attractive and cryptic sector is more resilient than most people give it credit for. They will continue facing tough times for at least a few months, but if the past is any indication, they will come out swinging.