Hedge Fund Closures: Ebola or Just a Nosebleed?

We’re usually content to let sleeping dogs lie after issuing an opinion on mass media bias against hedge funds. But, we have to quickly follow-up on Tuesday’s posting about hedge fund attrition. We argued that creative headline writers continue to have a hate-on with hedge funds, cooking up story titles like “1000 hedge funds may sink in turmoil” in reference to the industry’s rather unnoteworthy 10% turnover rate.

That same day, MarketWatch published a story entitled “Hedge-fund hemorrhage: $60 billion liquidated in last three years, shrinking investor options.”

Pa-leese, $60 billion in a $2 trillion+ industry over 3 years is a nosebleed and in no way suggests the industry is a hemophiliac.

Says MarketWatch:

Funds representing almost $7 billion in assets have shut down so far this year, according to research published by Absolute Return magazine, a unit of HedgeFund Intelligence. Add that to the approximately 50 hedge funds representing $18.6 billion in assets last year, and the 83 funds managing approximately $35 billion that were liquidated in 2006 (including the collapse of a single firm, $9.1 billion Amaranth Advisors that year) and you have fewer choices in which to invest your money.

Translation: If the Q1 trend continues, 2008 will be an average year for industry turnover and way below that of 2006.

You could actually be excused for being a little surprised that closures are so low. As any new industry matures, increasing concentration among larger competitors means that there are necessarily more players shutting down than opening up. What matters is the aggregate (asset) size of the industry and its returns, not the particulars of its ownership structure.

One of the main reasons why hedge fund closings are news at all is that hedge funds are small, independent businesses. So when one shuts down and gives money back to investors, those assets must move to another firm. Mutual funds close all the time. But they call it a “merger” with another fund managed by the same firm. It’s basically the same thing without the colourful headlines.

Another reason hedge fund closures make for great headlines is that unlike, say, restaurants (which are small businesses with way higher failure rates), there is confusion about the extent to which investors are impacted. As long as a restaurant doesn’t shut its doors while you’re eating there, its eventual closure is inconsequential to you. (see related posting on definition of “blow-up” written during the great hedge fund blow-up of 2006. Remember that? Neither do we.)

The obvious bias in the MarketWatch story shines through in the following zingers:

Sometimes assets are returned to investors. Other times losses are too grave and there is no money left to return. [What percentage of fund closures actually result in there being “no money left”?]

The issue with hedge funds of funds is that each of those underlying managers also gets paid a fee — and that takes away from investors’ returns. [Or here’s another theory…that is what gives an incentive to create “investors returns” in the first place - returns that handily beat the S&P 500 last year.]

Like several other recent stories with attention-grabbing headlines, this one contains a reality check buried deep in the final paragraphs - apparently a little too deep for the time-starved headline writer:

What’s also important to note is that the amount of assets under management that these closings represent compared to the entire hedge fund industry is small.

In other words, the hedge fund industry is in no danger of bleeding to death.