Drake's rocky passage

NEW YORK (Fortune) -- A high-profile New York hedge fund has notified its investors that it is pondering shutting several of its key portfolios because of a brutal combination of poor performance and lack of liquidity in key markets.

Drake Management, a once-high-flying bond fund manager whose flagship fund returned an astounding 41% in 2005, has been in hot water for several months as a series of large trades moved against the fund.

Last year, the once-$3 billion Global Opportunities fund dropped around 25%, leading investors to flood Drake with $1 billion in redemption requests in early January. On February 29, fund management suspended withdrawals from another series of its funds, the Low Volatility Fund group.

In a letter to Drake's investors sent last night - which Fortune obtained - fund management laid the out the stark choices management is pondering for its investors: Wind down its Global Opportunities funds, invest in a new fund or hold on, hoping the markets turn around. The wording of the letter implies that fund management hopes that investors will seek to invest in a new Drake fund.

The fund restructuring, if its investors allow it, represents a massive reversal of fortune for the Fifth Avenue-based investment manager, which had nearly $7 billion in hedge fund assets under management as recently as last year, and $10 billion firm-wide.

That Drake's Global Opportunities fund finds itself in these dire straits is odd, given that it is a macro-fund, with a charter allowing it to invest in most asset classes. Many of its peers in the macro strategy have had a good start to the year, at least according to the CS/Tremont index, posting an average gain in January of 4.44%.

Many funds in this sector continue to post outsize gains on bets against the dollar and on the rising price of oil.

While it is not clear how precisely Drake wound up in such trouble, hedge fund-of-fund managers who have monitored the Global Opportunities fund and its performance told Fortune that Drake put on a series of trades last fall that did not work out. These included betting on the decline of the price of the dollar versus the yen, a drop in long-dated Treasury bond prices and a rally in U.S. stock-market prices.

All three bets failed. When the trades did not pan out, Drake's Global Opportunity was forced to book a 14% loss and then suffered another 10% decline in November.

Soon after, the fund was forced into an all-too typical scenario: Increased margin requirements and requests for additional collateral. Drake's letter also references "predatory trading" with respect to its counter-parties, the big brokers. This means that dealers are no longer risking their own capital, or even providing narrow bond bid-ask spreads, to Drake in a bid to win the fund's trading business. In essence, the brokers know that the fund is weak and have little risk in trading against it.

Also, its large fixed-income holdings in its other hedge funds suffered from a decline in prices and liquidity as the credit crisis spread across the bond spectrum.

An outside spokesman for Drake declined comment.