Who Will Survive Hedge Fund Bloodbath?

This post first appeared on Minyanville.

After their worst year in decades, hedge fund managers are struggling to convince investors their high fees are worth the risk.

The Wall Street Journal reported this morning that the industry's collective influence may be weakening, as some funds are resorting to fee cuts to keep investors from withdrawing their money.

Most hedge funds charge a flat fee of 2% of assets under management, plus an incentive bonus of as high as 20% of profits. The idea is that hedge fund employees are best-of-breed: The chosen few deft enough to outmaneuver the market and rake in big profits.

But the events of the past 12 months have proven that whippy markets, government intervention and bank failures can cut even the savviest of investors off at the knees. Traders can hardly leave on a Friday without wondering what large financial institution(s) may not exist come Monday morning.

Hedge fund managers are charged not only with generating returns on an absolute basis (i.e. a pure percentage gain), but insulating investors from market risk. A common metric to evaluate the market risk of a given investment or portfolio is beta, which measures the correlation of the asset (or group of assets) to the broader market. A beta of 1 means a stock moves in lockstep with the major indices, while a measure of -1 means it moves inversely to the market.

The best hedge fund managers can generate strong returns with a low beta, keeping its investors' exposure to broad market risks at a minimum.

As one hedge fund analyst explained to me,

“The whole industry and fee structure is predicated on superior risk adjusted returns in comparison to the broad securities markets. There were plenty of funds out there who
were just generating excess returns by use of leverage and concentrated positions. These funds are now being exposed.

They were generating superior returns on an absolute basis, but have now been exposed as having generated poor returns on a risk-adjusted basis. These funds will go away, and capital will naturally flow to those that have consistently generated good risk-adjusted returns over a long period of time.”

Our recent -- and now long gone -- period of easy money and mispriced risk meant funds that ignored this mantra rolled the dice and made out like bandits. In some cases, literally.

Now, with the implosion of Caryle Capital earlier this year due to hugely levered bets on Fannie Mae (FNM) and Freddie Mac (FRE) mortgage bonds, as well as high-profile losses at funds run by such bulge bracket firms as Goldman Sachs (GS) and Morgan Stanley (MS), a weeding-out process of weak funds is well underway.

The beneficiaries are likely to be those best of breed: The managers who can successfully navigate even the toughest of markets. It's a task, however, that's easier said than done.