HEDGE FUNDS:The credit crunch of 2007 and the ongoing economic climate has meant that hedge funds are facing harsh realities, writes Fiona Redden.

'HEDGE FUNDS, like derivatives, are like NFL quarterbacks: they get too much of the credit and too much of the blame. The trick for investors is finding a winning hedge fund team. Trouble is, the field is getting really crowded," said Gerald Corrigan, former president of the Federal Reserve Bank of New York.

It used to be so easy for hedge funds. When experienced fund managers got tired of making more money for their firms than for themselves, they simply jumped ship to set up their own hedge fund. With markets booming, many managers became enormously wealthy as the money poured into their funds.

However, the credit crunch of 2007 and a slowing global economy means that for many hedge funds, the days of the easy money are long over.Most severely affected are hedge funds exposed to collateralised debt obligations (CDOs), financial products which pool and securitise different kinds of corporate bonds, mortgages and derivatives.

Up until the credit crunch of last summer, the CDO market had been one of the fastest growing segments of the fixed income markets with a market value of some $2 trillion (€1.27 trillion) in 2006. However, many of these securities contained sub-prime mortgages, so when that market collapsed, many CDO hedge fund managers were close behind.

There have been many high-profile casualties of the credit crunch including two of US bank Bear Stearns' CDO-based hedge funds in June last year: the Bear Stearns High-Grade Structured Credit Fund and the Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund. The funds were heavily exposed to the US sub-prime mortgage market and, as a result, lost nearly all of their value, causing investor losses of approximately $1.8 billion (€1.14 billion).

These losses, combined with further losses in the mortgage-backed market, meant that the bank faced insolvency before being bailed out in an acquisition by JP Morgan in March.

And it wasn't just the bank that suffered. In June of this year, the Securities and Exchange Commission charged two former hedge fund managers at Bear Stearns, Ralph Cioffi and Matthew Tannin, for fraudulently misleading investors about the financial state of the aforementioned hedge funds and their exposure to sub-prime mortgage-backed securities before the collapse of the funds. Other funds have also suffered. Boston-based Sowood Capital Management closed last year after a $1.5 billion (€955 million) loss, while John Meriwether, of the infamous hedge fund Long Term Capital Management which caused a global financial crisis in 1998, has since set up a new fund, JWM Partners, but this is also in trouble, falling by 31 per cent at one point last year.

More recently, Citi announced plans to shut down Old Lane Partners, a hedge-fund group it acquired from new Citi chief executive Vikram Pandit last year for more than $800 million (€508 million). Although one might expect that the current turmoil on global markets might actually present opportunities for hedge funds, overall they continue to suffer. Speaking at a conference in Monaco in mid-June, John Paulson, the top hedge fund earning manager in 2007, said that global write-downs and losses from the credit crisis may reach $1.3 trillion (€0.83 trillion), exceeding the International Monetary Fund's $945 billion (€600.3 billion) estimate.

"We're only about a third of the way through the write-downs," Paulson said. "There are a lot of problems out there and it will continue to be felt through the year. We don't see any signs of it stabilising."

In March, the hedge fund industry had its worst month since the collapse of Long Term Capital Management in 1998, when Hedge Fund Research's (HFR) HFRX index fell by 2.4 per cent. Then the funds reported their worst first-half performance in 18 years, when HFR's HFRI Fund Weighted Composite Index closed down 0.75 per cent on the year to June.

The biggest losers on the HFRI were emerging markets funds, which fell by 3.42 per cent in June, and by 6.74 per cent in the year to June. Other poor performers in the HFRI indices were fixed-income convertible arbitrage funds, quantitative funds, event-driven funds and relative value funds.

Hedge funds were also hit hard after wrongly betting that market inflation expectations in the UK would fall. The Bank of England reported that many funds were badly burnt after market expectations for inflation rose to a new high, most recently hitting 4 per cent for the first time since 1997.

It is also getting more difficult to launch hedge funds. After the rush of new launches over the past few years, the market has finally slowed. The first quarter of this year saw the fewest new launches since 2000, down to 247 from 251 in the same period last year and the lowest quarterly total for eight years, according to estimates by data provider HFR.

In the current climate, investors are expressing a preference for funds with established track records and significant infrastructure rather than new fund launches. According to HFR, firms with more than $1 billion (€637 million) under management hold nearly 87 per cent of total industry assets. Moreover, hedge fund liquidations are also on the up - 170 hedge funds liquidated during the first quarter of this year compared with 138 in the same period last year.

Single-manager hedge funds were hit hardest, with 155 funds shutting their doors in the first quarter, while equity-focused strategies saw the greatest turnover, say HFR, accounting for more than 50 per cent of both launches and liquidations. The slowdown is also impacting on the industry's philanthropists. In London last month, Arki Busson, the head of EIM, a $15 billion (€9.53 billion) fund of hedge funds, held the annual charity ball for his charity Absolute Return for Kids. It attracted the leading lights of the global hedge fund industry as well as celebrities such as actress Uma Thurman.

Although the event brought in a whopping £25.5 million (€32.25 million), the total raised was down by over £1 million (€1.26 million) on the record £26.8 million (€33.8 million) raised at last year's event. But the fact remains that the industry still had £25 million (€31.5 million) in spare cash to splash out on Busson's charity event, while some hedge fund managers had their best year ever last year. The top 25 on Alpha Magazine's annual ranking of the 50 most highly paid hedge fund managers earned an average $892 million (€566 million) in 2007, up from $532 million (€338 million) in 2006.

Top of the heap was New York-based Paulson & Company. Paulson correctly predicted that sub-prime mortgages were at "bubble-like" prices, and by shorting them, his fund soared by 591 per cent.

Dublin-based multi-manager Abbey Capital, which has $1.5 billion (€955 million) in assets under management, focuses on Commodity Trade Advisor (CTA) funds and managed futures, so its funds didn't take a direct hit from the credit crisis.

With commodity prices booming, the firm's flagship fund posted a 14.5 per cent increase in the year to May.

KBC Asset Management launched its Irish alternative business with one fund of hedge funds back in 2002 and since then has built up a business with €300 million in assets under management across six funds.

It has four single strategy funds, three of which are equity market neutral and the other one is a currency relative value fund.

Donnacha Loughrey, head of alternative investments with KBC Asset Management, says that although KBC was immune from the direct effects of the sub-prime debacle as it didn't have exposure to the market, it still suffered indirectly. KBC's flagship fund is down around 1 per cent year to date, but showed a positive upturn in May.

Nevertheless Loughrey is confident that the future looks brighter. "The worst is behind us, there are lots of reasons to be positive," he says.

"Banks' reluctance to lend provides an opportunity for distressed managers to provide rescue finance," he says, adding that there is a huge hangover of leveraged loans driven by LBO/M&A activity, which are now available at quite an attractive price and hedge funds can cherry-pick those loans. He also cites municipal bonds as offering attractive arbitrage opportunities at present.

Moreover, money continues to flow into the industry as more traditional type investments continue to offer a very poor return in the current environment. "Hedge funds have demonstrated throughout the downturn that they offer good diversification properties, as they have a low correlation to property and equities, so there are still good reasons to invest in hedge funds," says Loughrey.

In the six months to April 2008, single-manager hedge fund assets jumped by 9 per cent, as $230 billion (€146 billion) flowed into the industry, bringing the global total to $2.9 trillion (€1.8 trillion), according to a survey of assets under administration by Hedge Fund Manager Week.

The combined industry total for hedge fund assets is $4.4 trillion (€2.8 trillion), up from $4 trillion (€2.5 trillion) six months ago. Over the 12 months to April 2008, single manager assets grew by 20 per cent - a remarkable increase in a difficult trading environment. But the rate of growth has slowed. For the same six month period in 2007, assets grew by 17 per cent, compared to 9 per cent this year.