Coronavirus turmoil delivers shock to the hedge fund industry

Earlier this year, hedge fund tycoon Ray Dalio admitted that he and his team at Bridgewater Associates were “idiots” when it came to pandemics. The best they could do was to go straight through the market turmoil triggered by coronaviruses.

“It would be a mistake to snoop around by canceling our reaction to the latest titles,” Bridgewater told investors in late February.

A month later, Bridgewater’s flagship hedge fund Pure Alpha posted a 14% loss for the year to March 18, while a more aggressive version of the fund was down 21%. Mr. Dalio admitted that – despite a carefully maintained image of economic soothsayer – he was simply wrong.

“We did not know how to navigate the virus and chose not to because we did not think we had an advantage in marketing it,” he told FT at the time. “So we stayed in our positions and in retrospect, we should have reduced all the risks.”

The argument of the hedge fund industry is that it aims to make money under most market conditions and protect investors’ capital in the event of a downturn. This was questioned during the 2008 financial crisis, when the average hedge fund lost 18% – significantly better than the stock markets, but a steep drop nonetheless.

Over the past decade, the entire industry has suffered from a period of poor performance. Record interest rates and a multi-year bull market driven by central banks injecting money into the system have favored cheap index tracking funds and made life difficult for those pursuing more complex and costly strategies .

For years, hedge fund managers have been looking for more volatility. Supporters of the industry predicted it would prove itself with renewed turbulence. Despite the bleak reasons for the current market chaos – and the heavy human and economic toll of the pandemic – those looking for more volatility now have their wish.

Initially, the hedge fund industry as a whole held up rather well during the turbulence. The average hedge fund lost just 1.4 percent in February, according to Hedge Fund Research, despite buoyant markets. But initial resilience has waned as the turmoil has gradually deepened, detonating previously reliable transactions. Hedge funds have now fallen 8.6% in March and almost 10% for the year, HFR said.

This setback comes at a precarious time. Hedge funds have already experienced investor outflows for 13 of the past 17 quarters – with dynamic markets helping to keep sector assets under management at around $ 3 billion – and the number of businesses has declined for five consecutive years . Many of those who remain are less profitable. A long period of disappointing returns led to downward pressure on commissions, making the classic “2 and 20” structure a management fee of 2% and a performance fee of 20% the exception rather than the rule.

The current crisis therefore offers an opportunity – and for many managers, a last chance – to prove their value, according to investors and insiders of the sector. But many fear that it is no longer likely to cause another massive elimination of hedge funds in the manner of 2008 – the smallest being particularly vulnerable – and to reshape it in a profound way.

“What is happening now is epic,” said Mark Connors, a former hedge fund manager who now works at Credit Suisse’s main brokerage office. “The industry will not be the same after that,” he added, predicting that many funds will fall by the wayside, while the big ones will get bigger.

There have already been victims, such as Malachite Capital Management; and some Manikay Affiliates funds return capital to investors. Many others are suffering their biggest losses since the 2008 financial crisis and are baffled by the daily challenges of trying to navigate the markets.

“It’s like putting on a bulletproof jacket and jumping on hand grenades that go off every day,” said the head of an American hedge fund. “And I feel like I’ve lost parts of my body.”

Meanwhile, hedge funds are facing constraints on their investment style while some European countries ban short selling, the practice of betting on falling prices.

“You can’t blame short sellers just because some industries [or] companies are doing very badly these days, ”said Lionel Melka, fund manager at HOMA Capital. “Throwing the thermometer in the bin does not lower your fever.”

There has been a wide dispersion of performance between hedge fund strategies, between individual managers and even within multi-strategy funds. Most strategies have suffered at least a stretch of stomach churning losses.

Two weeks ago, hedge funds that sought to profit from slight differences between nearly identical US treasury bills, or treasury bills and treasury futures, were hammered when these spreads widened instead to shrink, threatening to cause a series of failures.

Line chart of the performance index showing that hedge funds have lost ground compared to passive balanced investments over the past decade

The strategy is popular due to its usual stability and, therefore, companies use lots of levers to increase returns. But when normal correlations collapse and all assets sell together – as they did two weeks ago – things can quickly go wrong. Fund managers have said that the aggressive Federal Reserve monetary easing has stifled the bleeding, but not before some of the biggest names in the industry have been hit, including Citadel and Millennium Management.

More recently, the pain has been more acute among traditional long / short hedge funds that bet on and against stocks, and certain computerized “quantitative” strategies. Last week was a hedge fund deleveraging Armageddon, according to Yin Luo of Wolfe Research. Event funds that merge commercial companies were also among the victims.

Hedge funds looking to keep up with market trends have also disappointed somewhat. Trend monitoring strategies increased by 18% in 2008, but have experienced significant difficulties since then. If they don’t prove their value now, “there is no reason for them to survive,” said a large investor.

Column chart of the number of hedge funds worldwide (000) showing that the hedge fund industry is slowly declining again

On the other hand, some global macroeconomic funds – which bet on major economic trends – have managed to take advantage of recent volatility more than most. Investors say Brevan Howard Asset Management and Caxton Associates posted double-digit gains this year thanks to bets on rising bond prices.

Given the turbulent markets, many investors will assess their hedge fund allocations, and the result should be more exits. Simon Lack, a former hedge fund distributor at JPMorgan, who has become an industry critic, said: “If they lose just a little less than stocks, then I think a lot of investors will ask, what’s the point? “

Leave a Comment