The New Year will be Better for Hedge Funds

December 17, 2011

2011 may turn out to be a seminal period for the hedge fund industry that could change it for the better, because it certainly can’t get much worse. Closing out its second losing year in four, the industry is facing tremendous pressures from all sides – disappointed investors, tax-hungry politicians, low cost and better performing index funds, regulators, tightening of lender financing – that are beginning to manifest themselves in many damaging ways. Many thought it was all over for hedge funds following the 2008 calamity that saw funds lost an average 20 percent. But, realizing that that was much better than losing 40 percent in the stock market, investors have stuck with their hedge fund managers.

But, in the last few years, hedge fund returns have either underperformed the market or mirrored them, which is not what investors are paying fund managers for.  With the uncertainty of the euro-crisis and the fiscal stalemates here at home, the market have been experiencing a volatility never before seen.  While investors do recognize that these are not normal times, they still expect a performance that minimizes their risk. How do fund manager’s like John Paulson explain to their investors how they managed to lose 40% while the market ends up flat?

The silver lining for Paulson and other fund managers has been that investors are not yet running from the theater yelling “fire!” For now, it comes down to a matter of alternatives, of which there aren’t many. So, fund managers will be given a chance to turn it around in 2012, but the leash is growing tighter and shorter. While the net inflows for the industry are still positive, the cross-flows are increasing with investors becoming more selective in their fund choices.

2012 could be a year of redemption for hedge funds (no, not the bad kind of redemption), but it won’t come without some pain. We are likely to see many more fund closings, which wouldn’t be a bad thing for the saturated industry. We should see fund managers continue to lower their fees, also not a bad thing. We will see some of the smaller, more nimble funds that scored decent returns this year, become the new darlings of the industry.  What should be coming, and it could turn out well for everyone, is a good old fashioned shakeout.


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