Hedge funds to survive despite Madoff scam

The breathtaking extent of concealed losses and apparent fraud at Madoff Securities and its hedge fund advisory business certainly defies logic and begs belief as to how it could go undetected for so long. The fact that most asset vehicles caught up in the financial black hole is alternative asset management firms has focused the spotlight on hedge funds again. The hedge fund industry is certainly facing its most difficult period on record since Alfred Winslow Jones launched the first hedge fund nearly 60 years ago.

The investment managers, hedge funds and financial institutions risk management framework and due diligence must be questioned as to its robustness. However, just as much, if not more, questions need to be thrown at the US regulators and supervisors. It appears that the fund was trading on an insolvent basis for many years. Moreover, it was not only hedge funds and fund of hedge funds that were caught out by the pyramid type scheme that saw investors exiting paid out by fresh funds coming in from new investors.

The debacle, with losses so far estimated at around $50 billion (Dh183.67bn), caught out some blue chip hedge fund names from Fairfield Greenwich to Tremont to Man. However, not all the exposure was from hedge funds. A significant amount of the exposure was to more mainstream institutions such as HSBC. Moreover, some of the exposure was collateralised lending and trading activities.

Nonetheless, coming at the end of the hedge fund industry's worst return performance year on record, in additional to substantial and steady outflow of funds from investors which has led many to shut exit gates, has questioned the long-term survival of the industry.

However, the announcement of the hedge fund industry's death is premature. Undoubtedly, a number of hedge funds and alternative asset managers will close or merge. The failure rate is also expected to increase over the six months, with perhaps a further 20 per cent winding up.

2008 had proved to be the hedge fund industry's annus horribillis. Performance of hedge funds to mid-December 2008 had been very weak, with main hedge fund indices, such as Credit Suisse Tremont and Barclays Hedge, down by around 20 per cent. The former index will likely see a further fall in December as two funds that contribute to it – Kingate Global and Fairfield/Sentry, have seen their assets marked down to zero due to the Mahoff fraud. Some specific strategies are down further. For example, fixed income arbitrage is down by 28 per cent and emerging markets are down by 30 per cent.

The 20 per cent fall across the general hedge fund index, despite being nothing to boast about, is still far better that traditional asset class indices. The S&P 500 for example is down by 38 per cent, the Dow Jones World Index is down by 45 per cent, and the Dow Jones World Emerging Index has fallen by 55 per cent. Hence, hedge funds have performed comparatively better.

In part, hedge funds have been tainted through guilt by association. Mahoff's dealings and financials were very opaque, criticism often thrown at hedge funds, in many cases justifiably. Mahoff's trading methods were never clearly explained, with the defence of 'proprietary strategy'; again, similar to many hedge fund vehicles.

The biggest challenge for the hedge fund industry is to try and restore its damaged reputation. The latter, in addition to losses, is resulting in continued redemptions and little new money going into hedge funds. Going forward, hedge funds will undoubtedly face increased external scrutiny. Their internal risk and regulatory structure will need to be enhanced significantly. Fund of hedge funds will also need to ramp up their due diligence process in order to try and prevent being caught out again. Hedge funds' operating model is likely to change, particularly the current prime broker arrangement. Separate ring-fenced trading accounts are likely to be the norm going forward.

The latest incident in the hedge fund industry is certainly another body blow. However, the hedge fund industry will survive and positives in terms of operating and risk structure improvement should occur.

- The author is a US-based commentator on business issues