Hedge Funds Struggle to Maintain Prestigious Image Amid a Barrage of Embarrassing Headlines

The reputation of hedge funds as a safe harbor for assets during market downturns has suffered numerous blows in the past year.  Through July, hedge funds were down 3.5% this year, according to data tracker Hedge Fund Research.  Investors may begin to ask themselves if the meager outperformance of the stock market is worth the risk of investing in a typically highly leveraged investment vehicle.  Remember Peloton Partners spectacular blow-out earlier in the year?  What about the seizure of Carlyle Capital by its lenders in March?  The number of internal hedge fund implosions and bailouts at investment banks in the past year (Bear Stearns, Citi, UBS etc.) have made it hard to believe that investment banks are still offered capital to manage.  The current CEO of Citi, Vikram Pandit, became a contender for the top post because Citi paid $800 million for his hedge fund Old Lane Capital despite unspectacular returns.  Since then, the fund has been shuttered due to disappointing performance and Citi has taken yet another writedown related to the restructuring.   

If you open the Wall Street Journal's Money and Investing section today, two highly embarrassing stories related to hedge funds may catch your eye.  First, a piece about how WexTrust Capital bilked a group of Orthodox Jews out of at least $100 million through an alleged ponzi scheme, followed by a story about an ex-UBS trader's hedge fund that has posted losses of 85% since the inception.  There is nothing funny about siphoning money from religious investors, many of whom based their investment decision on an uninformed Rabbi's personal recommendation.  The ex-UBS trader story, on the other hand, is kind of funny, although obviously not for any of the investors who have lost 85% of their money.  First of all, the founder of SRM Global, Jonathan Wood, managed to negotiate a five year lockup out of his investors when the fund was founded in September 2006.  Then he proceeded to invest in nearly every high profile flameout of the past year.  He was a big shareholder in Northern Rock, the U.K. bank that was bailed out by the Government.  Mr. Wood has since accused the U.K. government of using an unreasonable valuation process when it bailed out the bank, and that shareholders were shortchanged.  He also criticized Bank of America's bid for Countrywide as being too low.  The fund owned 8% of Countrywide as of early April.  Mr. Wood seems to have trouble accepting the ramifications of investing in insolvent financial institutions.  One can argue in Mr. Woods' defense that he merely picked the wrong sector to invest in.  However, the fund also owned Cheniere Energy, whose shares are down 86% for the year.  The energy sector has outperformed the overall market this year.  Yet, somehow, Mr. Wood managed to find the one energy stock that has posted a performance equivalent to a bank with subprime exposure.

Only one positive hedge fund headline has hit the papers this week, and it was related to an eye-popping compensation package.  Adam Levinson, the chief investment officer of the $8.8 billion global macro hedge fund was awarded a $300 million share grant by his bosses at Fortress Investment Group.  The fund has a solid performance history, although it is down 2% for the year.  Mr. Levinson reduced his profit-sharing interests in certain Fortress funds in return for the 31- million-share grant.  Mr. Levinson's trade of a huge chunk of equity in return for a reduced profit-sharing arrangement on a fund that is down on the year (i.e. profit = $0) is quite savvy.  Now that is great trade, for Mr. Levinson of course, not necessarily for Fortress' shareholders.  But if he routinely makes trading decisions such as this for his hedge fund investors then he is certainly worth the money.

Without a doubt, the large reputable hedge funds who have generated outsized returns to their investors for many years will continue to thrive.  In particular, the funds that saw the housing bubble from a mile away and managed to architect the right trades to profit from it will have no trouble raising capital.  But the days of raising $1 billion in a month just because you worked at a high profile investment bank are probably over.  Getting leverage of 100-to-1 from your prime broker will more than likely not be an option, making it harder to generate high enough returns to justify your fees.  Hopefully, the days of raising hundreds of millions of dollars on a Rabbi's recommendation are over too.  This is unfortunate for me alone, because I had a great investment strategy I was just about to pitch to my Rabbi this afternoon...