Once-invincible hedge funds brace for bad 2009

updated 7:41 p.m. ET Jan. 13, 2009

NEW YORK - Year after year, the hedge fund industry dazzled Wall Street by delivering "absolute returns" — outsized profits whether markets rose or fell. Using sophisticated trading models, the pools of managed capital made wealthy people wealthier with eye-popping returns that carried seemingly moderate risk.

Not these days. Blind-sided by a colossal market collapse and the widening Bernard Madoff scandal, hedge funds suffered their worst showing on record last year. And they're bracing for more pain in 2009. The industry's fall proves that even the quantitative brilliance and market wizardry of elite hedge funds are no magic bullet for investors during brutal times.

"Hedge fund managers have always said, 'Look, we know how to make money even in difficult times,' and that turns out to be a fallacy," said Timothy Brog, portfolio manager of New York-based hedge fund Locksmith Capital Management.

Nearly 700 funds — 7 percent of the industry — shut down in the first three quarters of 2008, up over 70 percent from the same period last year, according to Hedge Fund Research, a Chicago-based data firm. At that rate, roughly one in 10 hedge funds will have disappeared last year when final numbers are released in coming weeks.

Thousands more are expected to die in 2009 as investors who have been clobbered by losses yank out what's left of their money. Those investor redemptions have forced many hedge funds to liquidate large chunks of their assets, triggering "dramatic" swings in the stock market late last year, Brog said.

"Even if hedge funds make up only 10 percent of the market, it's going to have a big effect if they sell all at once," he said.

Besides the financial crisis and massive losses from Madoff's alleged Ponzi scheme, self-inflicted wounds also haunted hedge funds, experts say. The funds' high-octane investment philosophy, they say, pushed many managers to make big bets with borrowed money despite the dangers.

"We grew into this culture of gunslingers," said Bill Fleckenstein, founder and president of Seattle-based hedge fund Fleckenstein Capital.

For many hedge fund managers, the notion of managing risk through cautious trading was a "recipe for getting fired," he said.

"All anyone really wanted was performance, and managing risk was a drag on performance," Fleckenstein said.

The average hedge fund lost 18 percent of its value in 2008, the industry's worst performance on record and down from an average gain of 9.96 percent in 2007, according to Hedge Fund Research. The only other negative year on record was in 2002. But even then, funds only lost an average of 1.45 percent.

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Still, compared with the wider market, hedge funds don't look so bad. The Dow Jones industrial average lost 34 percent in 2008, while the Standard & Poor's 500 index fell 38 percent.

But hedge funds were never supposed to lose money.

The loosely regulated pools of capital burst onto the investment scene in 1990 with $39 billion in assets and quickly ballooned in numbers. Today, there are some 10,000 hedge funds, most of which cater to wealthy investors and promise big returns in virtually any economic climate.

Many hedge funds use complex models to trade crude oil and soybean futures, derivatives and other exotic assets out of reach to ordinary investors. Investors typically are charged a yearly fee equal to 2 percent of assets and 20 percent of profits. That fee structure has reaped eight- and even nine-figure paydays for the most successful portfolio managers.

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