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2006: THE YEAR THE HEDGE FUND MUSIC DIED? By Steven McIntyre and Todd J. Stein Print E-mail
by Special to    Sun, Jan 15, 2006, 12:00 PM

February 1st marks the day that most hedge funds with over $30 million in assets have to register with the SEC. Given the explosive growth in hedge funds over the last decade, it is no surprise that regulators are attempting to extend their reach into these private partnerships. Regulatory agencies are staffing up as they are assuming the asset growth will continue. We think that the inaccuracy of this assumption will be the biggest surprise of 2006.

When one mentions the idea of hedge funds folding, thoughts of Long Term Capital Management or Bayou Group come to mind. In the case of Long Term Capital, the implosion was primarily caused by overleveraging and a lack of risk controls. Bayou, on the other hand, was outright fraud. While we think there are many managers who are up to their eyeballs in leverage, we do not expect this to be the initial catalyst for an implosion in hedge fund assets. Similarly, we expect to hear about more high profile frauds in the coming months, but we don’t think the impact will be widespread enough to affect the overall level of hedge fund assets under management.

The chief cause of the coming collapse in the hedge fund industry will be lackluster returns. We have already seen it over the last few years. 2004 and 2005 saw both absolute and relative returns hover around the "flat to up a handful of percent" levels. And in 2003, most investors would have been better off in a NASDAQ or S&P 500 mutual fund. Someone in the industry was recently quoted as saying something to the effect that investors are starting to wake up to the fact that there are just not that many smart 29-year olds around! We wholeheartedly agree and see it ourselves when attending industry conferences. With an atmosphere that is chillingly similar to the Internet boom of 1999, one can find the next young hotshot fund managers with fancy sports cars, custom-made monogrammed dress shirts, expensive cuff links, etc – and this is before they start managing or earning their investors a single nickel. If there was a way to do it, we’d go short high-priced office space in Greenwich, London, San Francisco, Dallas, and Manhattan.

Getting back to the idea that hedge fund asset growth may be in line for a sharp slowdown or reversal, let’s examine how such a scenario would affect the financial markets. While the classic definition of a hedge fund is a portfolio where market risk is largely hedged, this is no longer the case. A hedge fund today is simply a loosely regulated investment partnership where most managers tend to lean long with leverage in expensive stocks and bonds. As returns continue to remain lackluster (almost a guarantee due to the law of large numbers) investors will get tired of the exorbitant fees and start to withdraw their capital. As managers scale down their portfolios to raise the cash needed, this will have a negative effect on other hedge funds as well as the markets overall. At that time, we think the systemic risk of a meltdown increases sharply as fund mangers worried about capital redemptions begin to swing for the fences in greater numbers. And it will be precisely at that moment when the mouth-watering bargains return. Stay on the sidelines and be prepared.

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