It wasn’t supposed to be like this. After all, most hedge funds pride themselves on providing clients with positive “absolute returns”—ie, on turning a profit whatever the financial weather. Until now that promise had been largely met. In 1998, the year that Long-Term Capital Management (LTCM), a giant hedge fund, collapsed, the industry still managed a small positive return. During the previous big financial bust of 2001 and 2002, when American shares fell by over one-third, the average hedge fund was roughly flat. This time, however, it really is different. Bans on short-selling have made many strategies unworkable. Poor management by hedge funds may be partly to blame: the industry has more than its fair share of illiquid assets that have been hammered during the crisis. But it also appears that forced sales of assets by hedge funds have driven prices lower, in turn hurting performance—a typical case of contagion. The 30 core American equity holdings of the biggest hedge funds, tracked by analysts at Merrill Lynch, have underperformed the stockmarket since the end of August.
What is the cause of the fire sales that seem to be at the root of the industry’s problems? The obvious answer is a withdrawal of credit, which has in turn forced hedge funds to offload assets. Sceptics have long argued that for all the skill they claim to possess, hedge funds just use cheap money to amplify mediocre returns. By this account they are simply another part of a vast, debt-dependent ecosystem that is now being starved of oxygen. Yet the role leverage has played in bringing the industry to its knees is subtler than this. And there is another prime suspect for hedge funds’ suffering: their own clients.
