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Hedge Fund: Canaries in the Coal Mine?

A string of hedge fund failures and closings in the last couple weeks may be an omen of an impending correction in global stock markets. The carnage of fund failures this year has been so heavy some are calling it a “hedge fund killing field.”

Industry data tracker HFR reported that 530 funds liquidated in the first half of the year, on pace for the second most shutdowns in a calendar year–the first was 2008.

Hedge fund performance is part of the problem. The HFI Americas Composite Index, which tracks a range of hedge fund strategies, gained 3.35% this year through August. That compares to a 6.21% gain for the S&P 500 and a 4.22% gain for the iShares Barclays Aggregate Bond Fund over the same period.

Hedge fund managers have blamed the bad performance on the corrosive effects of central bank stimulus around the world, which is upsetting long-established relationships between markets, economies, currencies and asset classes.

In fact, at a recent Bloomberg conference of prominent hedge fund investors, Oaktree Capital Group’s fund manager, Howard Marks, which manages $98.1 billion, argued that big institutional investors such as pension funds will earn annualized gains of only 5.5% in the future. And they may not be enough to fund their obligations to pensioners.

Risky Business

On the other hand, many hedge funds take big risks, and their managers sometimes make obscene amounts of money, so let’s not pity them.  Their strategies include one-way bets on currencies, indexes or economies that seem tantamount to gambling. Just this summer a hedge fund managed by Chelsea Clinton’s husband lost 90% of its investor’s money betting on a strong recovery in Greece.  

But many of the hedge funds going under aren’t making wild bets. Some have long records of market out performance, and they’re closing their doors and returning money to investors because they don’t think they can beat the market anymore.

One example of Wall Street’s finest leaving the game is Perry Capital. The firm managed $6.6 billion as of the end of last year, down from around $15 billion in early 2008, according to Reuters. Perry produced a gain for every calendar year until 2008, when just about everyone took a haircut, but recently has again lost money on its investments.

Last month founder Richard Perry, in a letter to shareholders, announced he was closing the fund and returning money to investors. “Although I continue to believe very strongly in our investments … market headwinds have been strong, and the timing for success in our positions too unpredictable,” he wrote.

We think the main cause for hedge fund failure is the contorted market brought on by central bank stimulus. When the effects of stimulus will end here isn’t clear, because just when one country’s central bank starts to taper off, others start. And stimulus doesn’t respect borders, so stimulus in Japan and Europe can boost markets in the U.S. and elsewhere.      

In any case, don’t cry for hedge funds, but consider that they may be a canary in the coal mine and markets may soon get very rocky. We average investors can hedge by sticking to conservative income investments, such as those we recommend in the Income Portfolio of Personal Finance.

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