Hedge funds: How bad was it for you?

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Many funds say the fall-out from GM/Ford has been overstated

Credit events in the autos sector in May have spurred concerns about hedge fund losses and their impact on the market. April was the worst month for hedge funds since September 2002, and doom-mongers are fearful that May will be even worse after convertible arbitrage and credit funds were caught out by the downgrades of General Motors and Ford Motor Company.

It has been rumoured that some credit hedge funds will have suffered losses of 10%-15% as a result of CDO exposure to General Motors and Ford, according to equity research from Morgan Stanley, and talk of hedge fund bankruptcies has been rife – although none have been confirmed. Combine this with news from the Centre for Economics and Business Research's that 20% of hedge funds will close over the next two years, and it is little wonder that market participants are getting nervous.

But even given the losses that credit funds may have suffered, Morgan Stanley estimates aggregate hedge fund returns to be down only 0.5% in May, with the two aforementioned styles being the worst hit. "It's just not as bad as everyone thinks," says one executive at a leading hedge fund.

However, the reaction of market participants has highlighted the importance of investor loyalty.

One major concern is that investors will over-react and start pulling their money out. Federal reserve chairman Alan Greenspan clarified the point at a banking conference in Chicago in May, saying that disappointment over returns were inevitable given the number of hedge funds chasing similar strategies, but that so long as investors do not force exiting funds to liquidate their assets, there should not be adverse affects on the market.

Worryingly Greenspan adds that, while historically investors have not been able to force the sudden liquidation of a hedge fund because investments have been subject to lengthy redemption or lock-up requirements, these days it's a different story.

"There are reports that institutional investors have been able to negotiate much shorter redemption periods," says Greenspan. "If institutional money proves to be 'hot money', hedge funds could become subject to funding pressure that would impair their ability to supply liquidity to the markets and might cause them to add to demands on market liquidity."

Those hedge funds that have favoured institutional money over high-net-worth money claiming it to be stickier may end up kicking themselves.