Ruminations on Hedge Funds
 By Nancy Zambell, Contributing Editor

The headlines paint a pretty dim picture of the financial industry. In the last couple of months, we've seen bank failures, with the worst being the second worst bank failure in history – the spectacular demise of the $32 billion IndyMac (which was precipitated by a line of depositors making a run on the bank), and the most recent ones, the First National Bank of Nevada and First Heritage, with offices in California, Arizona and Nevada.
 
 Then there are the mega write-offs of bad debt from financial institutions worldwide: $11 billion from Deutsche Bank, $32 billion from CitiGroup, amounting to, so far, a grand total of more than $112 billion from various companies in the industry.

The culprits primarily are the declining real estate market and the subsequent increase in delinquent loans and foreclosures, primarily in the sub-prime lending arena.

But the troubles aren't confined to just banks, mortgage companies and brokerage houses.

Hedge funds are also big investors in mortgages, and several have been hurt so badly that they've closed their doors.

• The Carlyle Group pulled the plug on Blue Wave, a $600 million hedge fund whose primary investments were mortgage-backed securities, and which posted a 17% negative return last year.
   
• In May, UBS shut down its Dillon Read Capital Management fund due to losses in sub-prime lending.
   
•  Citigroup just announced the closing of its Old Lane Hedge Group.

And in the first three months of 2008, 170 hedge funds were liquidated, compared with 138 in the first quarter of 2007.

The reason is in the performance. In July, hedge funds had their worst month since the Global Hedge Fund Index was created in 2004. According to Hedge Fund Research Inc., the index, which is comprised of more than 55 funds, dropped by 3.2% (through July /24), on the heels of some bad bets on financial stocks and crude oil.

In the United States, the blame for July's rout can be assigned to the rampant short-selling in shares of Fannie Mae and Freddie Mac, which had risen 11% and 28%, respectively, in the two weeks ended July 15, according to statistics compiled by Bloomberg. The short squeeze was on, though, when both agencies saw their shares more than double after the government announced intervention measures. On the other side of the investment arena, the sudden drop in oil prices caught all the bullish energy traders unaware, causing tremendous losses.

Halfway across the globe, Asia-focused hedge funds also hit hard times as investors placed just $530 million in their coffers in the second quarter – one-half of that invested in the prior period. And those funds being hurt the most are the smaller-cap equity funds as opposed to the larger funds that have invested successfully in the currency markets, for instance.

According to Hedge Fund Research, its HFRI Emerging Markets Asia ex-Japan index has declined by more than 13.8% year-to-date.

Most experts anticipate further consolidation in the industry, which probably could use some thinning of its ranks. According to the Cayman Island Monetary Authority, there are now 10,037 hedge funds registered in the Islands.
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For most investors, the fortunes of hedge funds don't have much impact on their daily lives, since their minimum investment can range from $250,000 to $1 million, and many individual investors just can't afford that kind of ante for one investment. However, what many investors and consumers don't realize is that those same mortgage woes that are killing their brethren right and left are actually creating opportunities for more fortunate hedge funds that are now investing in distressed loans and foreclosed properties across the country.

That's right - your mortgage loan may now be held by a hedge fund.

Always eager to make a buck, these hedge funds are hoping to profit from buying mortgages for pennies on the dollar, and selling the properties when the homeowner eventually forfeits, which is estimated to happen in one-half to two-thirds of the cases.

Merrill Lynch has just announced that it will buy $30.6 billion in distressed loans form Lone Star Funds, for a mere $6.7 billion. It is following the lead of other well-established companies such as BlackRock and Marathon Asset Management that have been buying up these mortgages for months now.

So it may not be too surprising that hedge funds are attracting some unlikely investors, including public pension funds, which have recently seen some pretty dismal returns, and many of which are substantially underfunded. According to Hedge Fund Manager Week, some one-half of the respondents in a recent survey said they are investing in hedge funds, with 41% of them admitting to increasing their allocations to the funds over the next three years. However, it's important to note that they are still only investing an average of 5%-10% of their total portfolios in these funds.

Hedge funds are cyclical. Like the stock market in general, they have good years and bad ones, typically spectacular successes and equally spectacular losses. And while most investors are not eligible, for those that are, there are a few rules to keep in mind:

Do your research. Make sure you thoroughly understand the fund's prospectus or offering memorandum, so that you are aware of the associated risks and ensure that the fund's strategies meet your goals, time horizons and risk tolerance.

Find out how a fund's assets are valued. Many funds invest in highly illiquid securities that make a thorough valuation very difficult, and remember that the funds are allowed considerable leeway when they value investments. You need to find out the details.

Pin them down on fees.

Find out the fund's limitations on redeeming shares. In many cases, funds limit redemptions to just a few times a year. Additionally, funds often impose a lock-up period of one year or more, a time frame in which you cannot cash in your shares.

Inquire about performance and make sure the quoted returns are net of fees. Hedge fund returns are classified as: Pro forma (assumptions, hypothetical), managed account (in which the firm manages individual accounts, outside of the existing hedge fund structure that may have existed prior to the inception of the hedge fund), estimated, confirmed, and audited. Make sure you know which return you are talking about.

Research the fund's management, their qualifications, as well as their disciplinary histories. Form ADV can be found on the Investment Adviser Public Disclosure web site:

http://www.adviserinfo.sec.gov/IAPD/Content/IapdMain/iapd_SiteMap.aspx

Or, on your state's securities regulatory site (for funds with less than $25 million under management):

http://www.nasaa.org/QuickLinks/ContactYourRegulator.cfm

Additional information can be found on the SEC's site:

www.sec.gov

One last reminder: Hedge fund investors do not have the same level of disclosure that you would expect from registered investments. And it may be very difficult to determine if the representations made to you are true. While the returns of many hedge funds do offer significant investment potential, this is one area where the premise of Buyer Beware should not be neglected.

This concludes this week's issue of Financially Fit.  We encourage you to visit our website to review past issues of Financially Fit:

http://www.brokeradviser.com/newsletter.cfm


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