Watch out for the next risk: a hedge fund death spiral

By banning short selling of financial stocks, securities regulators in Australia, Britain and the United States may have inadvertently added to the risk that the next down-leg of the financial crisis could involve a death spiral among hedge funds.

This has been a grim year for the hedge fund community, which has been hit hard by the credit crunch and subsequent financial crisis. Overall, the industry has lost money, with the Credit Suisse/Tremont Hedge Fund Index down 3.55 per cent for the year to August (see the first chart below).

That performance might not seem too bad, especially when major stock indices have fallen 20 per cent or more. But the decline gives the lie to hedge fund managers' claims to be able to profit in falling as well as rising markets, and will inevitably dent investors' enthusiasm for the sector. Few hedge fund managers are listed, but the shares of those that are have suffered heavily lately, with the London-listed Man Group down 40 per cent in the last three months (see the second chart).

Even worse, the modest drop in the industry-wide index masks the dismal performance of some popular hedge fund strategies. According to Credit Suisse/Tremont, funds specialising in convertible bond arbitrage were down 8.2 per cent for the year to August, while emerging markets hedge funds had fallen 10 per cent.

Hedge funds operating in Asian markets have performed even more poorly, losing on average about 20 per cent of their investors' money in the first eight months of the year, according to some estimates. Given the state of regional markets, most will have lost heavily in September, too.

Not surprisingly, hedge funds that specialise in short selling have done much better, gaining 10 per cent for the year to August. But now that regulators have banned shorting, hedge funds that employ the strategy, which include long/short equity funds and market-neutral specialists as well as dedicated shorts, are in trouble.