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Investors Hedge Hedge Funds


Performance will dictate who survives volatility.


Hedge funds are known for astute risk management and generating consistent returns in any market. Recently, however, many of these firms have been unable to navigate the unprecedented volatility.

The high-profile collapse of Caryle Capital last week shed light on the dangers of operating with extreme leverage, even in the market for highly rated mortgage debt backed by Fannie Mae (FNM) and Freddie Mac (FRE).

Even the venerable Goldman Sachs (GS) had its share of troubles - its flagship Global Alpha Fund lost around 40% of its value last year, according to Bloomberg.

While not all hedge funds use leverage, many will be out of business by the end of the year. According to Marc Freed of Lyster Watson Management, an investment advisory firm in New York, "Every couple of years, we go through a cleansing where we flush out some of the weaker hands. This may be one of those years."

Hedge funds are paid on performance - typically 10-20% of generated profit plus a 1-2% management fee. If a fund starts to lose money, investors don't have much patience for a recovery. With sophisticated investors looking for secure returns in these uncertain times, losing funds will assuredly see their capital base quickly erode.

Many funds are looking to cash in on the housing crisis. Goldman and other high-profile investment managers have raised over $20 billion to invest in distressed mortgage-backed securities. Pimco has accumulated $3 billion and Bloomberg reports even Bear Stearns (BSC) tried to scrounge up capital at an investor conference last month.

This money is proving harder to spend than raise. Despite the forced selling in the credit markets over the past month, supply and demand still can't come to terms. Hedge funds aren't finding prices that provide sufficient return, while sellers feel the illiquid markets are unduly hitting good quality assets.

For most funds, sitting on cash and waiting out market imbalances is not an option. We've seen what happens with forced selling. Could forced buying be next?

No positions in stocks mentioned.

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