By 2007, after years of dramatic increases, the total assets invested in hedge funds rose to about $2.5 trillion. In 2009, due to losses and redemptions stemming from the current financial crisis, that total is likely to drop to $1 trillion or less. How strongly the industry will bounce back from its annus horribilis is unclear. The global economic environment itself will be a major factor, as will the prospects of additional regulation. But just as important will be whether the hedge-fund sector can heal its own self-inflicted wounds.
Hedge funds are often misrepresented as being risky, secretive, highly leveraged, and unregulated. In fact, most hedge funds are none of those things. They are generally transparent (at least to their investors), subject to significant regulation, and less risky than most other investment options. The high representation of hedge funds in institutional portfolios in recent years has been due not to faddishness or recklessness, but rather to a recognition by sophisticated investors that hedge funds have reliably delivered impressive absolute returns (at least until last year).
Moreover, there is no such thing as a typical hedge fund. Each fund tends to adopt a specific niche for its investments -- long-short equity, currencies, commodities, convertible debt, distressed debt, senior bank or high-yield debt, mortgages, and so forth. Each strategy has its own risk and return characteristics. The funds are referred to as absolute- return vehicles since their mandate is to be profitable in most market environments, performing well even if, say, the stock market is flat or down. This turned out not to be the case in the systemic collapse of the fourth quarter of 2008, but it was true before then and has been true during the first quarter of 2009 (during which the S&P 500 was down almost 12 percent while hedge funds as a whole were positive).
So what went wrong for hedge funds during the crash of 2008? Two things: what the markets did to them and what they did to themselves.
The markets' influence was primarily
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