Signs of a healthy market? Tell it to the investors...

Hedge fund failures on the rise as market grows

By Pratima Desai
Reuters
January 17, 2006

A record number of hedge funds went bust last year, and the failure rate is likely to keep accelerating, but unfazed investors see this as a sign of health in a growing market. Chicago-based data provider Hedge Fund Research estimates that around 5.7 percent of the total of more than 8,500 hedge funds closed in 2005, compared with 3.6 percent of around 7,500 in 2004. The previous high was 5.5 percent of around 5,500 in 2002.

Over the next five years the casualty rate could rise to 10 percent or higher as more hedge funds enter the market to meet growing demand from institutional investors such as pension funds and insurance companies, investors say.

"More people are aware of how institutional allocations have changed," said Gavin Rankin, head of investment analysis in Europe at Citigroup Private Bank. "There is more demand. You will see many more hedge funds starting up.

"It's likely there will be more failures," he added. "But that doesn't necessarily mean blow-ups ... In most of those cases, the reason will be disappointing returns."

Institutions looking for a way to preserve their capital and diversify away from traditional assets such as stocks and bonds. have piled into hedge funds since the 2000 equity bubble burst.

Hedge funds are estimated to manage more than $1 trillion, and analysts expect that number to double to $2 trillion at least within five years. Last year 1,580 hedge funds went into business, compared with 1,406 in 2004, 1,156 in 2003 and 1,222 in 2002, HFR said.

TRACTION

Meanwhile, according to industry estimates, hedge funds on average returned less than 7 percent last year, compared with around 9.5 percent in 2004 and more than 15 percent in 2003. Data compilers do not publish hedge fund performance tables, because returns are reported to them under strict conditions of confidentiality. This makes it impossible to work out which are likely to succeed and which fail.

Looking at money flooding into the industry and tempted by the high fees that hedge funds earn -- typically 2 percent management fees and up to 20 percent performance fees -- many bank traders have jumped on the bandwagon. However, without access to the huge volumes of information available at major investment banks, many managers have struggled to satisfy return expectations.

HFR estimates the number of hedge fund closures last year at 484, 267 in 2004, 238 in 2003 and 297 in 2002. "There were a lot more guys coming out of banks setting up hedge funds over the last couple of years ... Some of them were not getting any traction," said Saleem Siddiqi, a partner at Tapestry Asset Management, a U.S.-based fund of hedge funds manager. Analysts estimate that hedge funds need to gather between $75 million and $100 million by the end of their first year to ensure long-term survival.

"They are now going back to banks, which have recently started re-hiring traders," Siddiqi said.

"Hedge fund closures are healthy for the industry," he said. "Our space is Darwinistic, and it's about the survival of the fittest ... It's about producing high risk-adjusted returns, (which) many of them weren't able to do."

Siddiqi said an analysis of the funds that closed last year would probably show that they had managed a small percentage of the total money invested in the industry. "Looking (only) at the absolute number of funds that closed is missing the point." Estimates for how much money had been managed by the failed funds are not available.

COSTS

Part of the reason for higher failure rates is the increasing involvement of institutions. According to French business school Edhec, European institutions have an average of around 7 percent of their assets invested in hedge funds.

European institutions, unlike their U.S. counterparts, have been slow to invest in hedge funds but are expected to catch up over the next few years. Some see the allocation rising to as high as 15 percent, while others think it could be 20 percent.

"Institutional investors demand a higher level of operational strength," said Mark Barker, co-chief investment officer at Pioneer Alternative Investment Management.

"A one-man band will not get the money anymore ... Today you've got the manager, probably a chief operating office maybe coupled with a chief financial officer ... It has become a lot more expensive to set up a hedge fund."

Also a rising tide of regulation of the industry adds to legal and compliance costs. Most hedge funds are registered in offshore, lightly regulated, low-tax centers such as the Cayman Islands. But in most major financial centres managers now also have to be registered with the local regulators. Hedge funds complain most about the costs and restrictions of new registration rules in the United States.

Check out hte original piece here.

-- MDT