NEW YORK (CNN/Money) -
Hedge funds have struggled to make money this year, which means that for the first time in recent memory, it's getting tough for them to attract new money as well.
While the firms that track hedge fund asset flows do not expect to have complete information for a few more weeks, some industry watchers think that the second quarter net asset flows were flat or even negative – meaning that more money went out of hedge funds than into them.
If so, it would be the first time in recent memory that hedge funds did not gain new money.
Investors poured billions into the white-hot investment vehicles in the first quarter, when hedge funds racked up close to $25 billion in new investments, according to Tremont Capital Management, a hedge fund investment and research firm based in Rye, NY.
The hedge fund industry took in $123 billion in new capital in 2004, compared to $72.2 billion for 2003, according to Tremont.
"The flows have slowed significantly," said Justin Dew, a senior hedge fund specialist for Standard and Poor's. "That is due to two things. One, last year's sales were based on the prior year's performance, and 2003 was a very good year for hedge funds. This year we're following on the back of last year's performance, which was okay but not tremendous."
Dew said the second factor is the difficulty credit markets have faced this year. With interest rates not behaving as expected and with bonds of automakers GM and Ford getting downgraded to "junk" status, along with the convertible bond market suffering a rout, many hedge funds that invest in those asset classes suffered negative performance.
Big losses in arbitrage strategies
The majority of outflows has come from funds that employ the battered convertible arbitrage strategy. In that strategy, managers buy convertible bonds -- those that can be exchanged for a certain amount of a company's common stock -- and short the underlying stock of the issuing company. The goal is to profit from the difference in price between the two securities.
The strategy has taken a well-documented drubbing, largely due to a vicious cycle that began late last year when investors in these hedge funds, unimpressed with lackluster returns, began asking for their money back. The redemptions forced managers to sell into a market with no buyers, driving returns even lower.
Tremont estimates that the funds that use the strategy lost $1.8 billion in the first quarter of 2005 -- a number that is sure to rise for the second quarter.
Some observers say that money has also come out of some of the largest funds-of-funds, which are portfolios of hedge funds. Investors in funds of funds pay a fee to a portfolio manager, who invests in hedge funds on clients' behalf.
Further underscoring the slowdown in asset flows, London-based Man Group PLC, the largest hedge fund manager in the world, saw its shares take a tumble in London after lower than expected growth in assets under management in the second quarter.
A short-lived slow down?
Despite the blah returns this year, experts think the slow down will most likely be short-lived, in part because investors still need to invest, and hedge funds have outperformed the broader equity indices for the past couple of years.
Said Dan Lancellotti, managing director and global head of capital introductions for Citigroup's prime brokerage business, "I think (asset flows) will pick up whether returns start building or not. This is a marathon, not a sprint. While (performance) may cause some people to pause momentarily, and rightfully so, (flows) will turn around as people realize that they have to put their money somewhere. People seem to be acting rationally. They are not panicking, and where it might be prudent to take money off the table they're doing that."
Long-time hedge fund professionals frequently cite the cyclical nature of asset flows, saying they seem to operate on a three to four-year cycle and are tied to economic events. For example, assets flowed out of directional strategies like long/short equity in 2001, when many long/short equity funds focused on technology stock got hurt after the burst of the telecom bubble.
Before that, assets flowed out in 1998, after Russia defaulted on its debt, an event that felled many hedge funds and led to the collapse of Long Term Capital Management.
To learn more about what investors are doing with hedge funds, click here.
For more on what regulators are saying about hedge funds, click here.