May’s credit market turmoil hit the profits of all four US brokers that reported second-quarter earnings last month, Goldman Sachs and Morgan Stanley especially. There’ll be more to come in July when the universal banks, and Merrill Lynch, report. JPMorgan has already warned that its trading results are the worst for some time. But the firm has at least had the chance to offset some of its problems with gains from June’s more bullish credit trading environment.
The brokers have no such luck. Nor do the hedge funds, and that has fuelled talk of their investors withdrawing money in significant amounts.
It might not come to that; if funds have made better returns in late May and June there is a chance some investors will cancel their redemptions.
But the problem hedge funds face is precisely that they are increasingly dependent on fearful, trigger-happy pension funds, mutual funds and insurance companies. These traditionally long-only, buy-and-hold investors are becoming the new hot money, on the lookout for high returns but quick to pull out at the first sign of problems.
The rapid growth in hedge fund assets in the past five years is in large part a response to the demand for higher returns from such traditional investors after the equity market collapse hit their performance figures. As more hedge funds started up they offered potential investors shorter lock-up periods, often just one month, compared with the three or six months, or longer, that used to be the case.
That’s great for attracting money, but gives jittery investors an easy out in tough markets. The recent development of hedge fund indices could make matters worse. Now investors have a monthly yardstick against which to measure investment firms whose very value used to lie in being free from the restraints confining the real-money accounts.
Some hedge fund managers are starting to grumble that their investors want the best of all worlds: a market-neutral fund investing only in mainstream strategies in liquid markets yet delivering excess returns. That’s tough to deliver, and risks turning a lot of hedge funds into little more than expensive mainstream investment houses, the very dumb-money houses they used to mock.
The real excess returns come from funds with an edge. That comes from knowledge, and often technology. But it also involves getting involved in illiquid products. Managers say the smart hedge fund money is now going into such investments as esoteric mortgage products, asset-backed lending and environmental credits trading.
There’s nothing wrong with traditional investors demanding more transparency from the hedge funds they invest in. But investors need to remind themselves what made hedge funds an attractive asset class in the first place.
