New Game Awaits Humbled Hedgies

Even so, and though their numbers might shrink in the coming months, the surviving hedge funds could emerge stronger than ever.
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The hedge fund era as we have known it may have come to an end, with returns evaporating, clients demanding their money and officials eager to tighten

regulation

, but experts say the industry is poised to emerge stronger once it consolidates, cleans up shop and opens the blinds.

While hedge funds are not required to publicly disclose much information, the industry stands to book its first year of negative performance since private groups first started tracking data about a decade ago. Hedge fund investments lost 22% of their worth through November, according to BarclayHedge, which collects data from around 2,200 funds. In light of the unprecedented turmoil and huge market shifts from day to day, few were nimble enough to avoid losses, leaving hardly any portfolio unscathed.

Compared with the broader market, whose indices lost closer to 40% over the same period, one could argue that hedge funds are still outperforming. But that argument, and promises of better days, provide little solace for clients paying alpha fees for alpha returns. As clients watched the

Bernard Madoff

scandal unfold, even the most trusting and daring started to demand their cash.

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Many hedge funds have responded by putting "gates" around assets so that investors must wait for a period before withdrawing funds. That strategy might buy time, but it won't solve the problem.

"Once the gates come up, people will withdraw anyway, so it's kind of delaying the inevitable," says Pierre Villeneuve, managing director of the quantitative hedge fund Mapleridge Capital.

While Mapleridge is one of the chosen few, generating returns of nearly 25% so far this year, Villeneuve estimates that about a quarter of the 10,000 hedge funds that existed at the start of 2008 will be gone once the smoke from the economic crisis clears. Others, like Harley Lance Kaplan, a certified financial planner with Beta Industries, are more bearish, estimating that only a quarter will be left.

However many hedge funds survive, experts predict that they will be forced to make more traditional investments, with less leverage and tighter regulation.

"We're not out of the woods yet," says Villeneuve. "I think we're going to see a dramatic change in the landscape."

The hedge fund boom began in the early part of this decade, fueled by cheap money, new investment vehicles and clients who were happy to take on extra risk for the chance at hefty returns. Many funds were launched by super stars on trading desks at Wall Street firms like

Goldman Sachs

(GS) - Get Report

,

Morgan Stanley

(MS) - Get Report

,

Merrill Lynch

(MER)

,

Lehman Brothers

and

Bear Stearns

, some of whom didn't have adequate experience or risk-management expertise.

The first sign of trouble came when two of Bear's own hedge funds collapsed during the summer of 2007 from heavy exposure to subprime-mortgage debt. Funds with similar strategies and huge leverage met a similar fate as the one-time heady market for those troubled assets quickly dried up. The problem soon spread to the rest of the debt markets, making it extremely difficult for heavily levered hedge funds to finance their deals.

Those issues combined with an accelerating economic malaise left little space to hide in the stock and bond markets. Enormous volatility -- ordinarily a boon for active investors -- added to the pressure, making it nearly impossible for anything but cash assets to stay consistently in the black.

"Madoff just put icing on the cake," says Villeneuve. "It's been an unbelievable year."

Struggles at major hedge funds can also have a ripple effect on the companies in which they have massive holdings, even if those companies are otherwise performing well. Funds would logically liquidate holdings that retained the most value, potentially causing danger for companies like

CSX

. Two hedge funds, The Children's Investment Fund Management and 3G Capital Partners, hold 9% of the company's outstanding stock, and one-third of its board seats.

Hedge fund collapses are nothing new and are somewhat unsurprising, since taking on huge risk can lead to huge rewards or utter despair. But the sheer number of highly levered firms facing payback demands has only made the tough market conditions tougher. Even the biggest and strongest funds have come under pressure, with

Fortress Investment Group

(FIG)

suspending its dividend to preserve cash and

Cerberus Capital Management

limiting redemptions.

And while hedge funds were blamed for fueling the downfall of firms like Bear Stearns and Lehman, and the circumstances that led to government-backed rescues of

Fannie Mae

(FNM)

,

Freddie Mac

(FRE)

,

AIG

(AIG) - Get Report

and

Washington Mutual

by shorting their stocks, not all funds were able to profit from or avoid the implosion of financials and autos this year.

Citadel Investment Group

acquired a majority stake in

E*Trade Financial

, only to see its value fall precipitously. Similarly,

Cerberus

, the majority owner of

Chrysler

and

GMAC

, the financing arm of

GM

(GM) - Get Report

, watched the automakers teeter on the brink of destruction over the past few weeks.

Any hedge fund that performed well was "either an anomaly or unreplicable. Everyone else has been hit right across the board," says Rachel Minard, president at Cogo Wolf Asset Management, a fund of funds. "What one has to be able to do in this market is move in and out of their positions and sectors with finesse and quickness. And that requires the liquidity that today is very hard to come by."

While Cogo Wolf has underperformed this year, it has placed a premium on walking clients through investment decisions to maintain and strengthen relationships: "Camaraderie, transparency, access," says Minard. The firm has managed to keep all of its clients while Minard scouts the globe for fresh capital from foreign investors.

Those that have been able to dodge the entire barrage, whether by strategy or luck, are few and far between, though some do exist.

John Jacquemin, founder of the Mooring Intrepid Opportunity Fund, laid out an investment plan in late 2005, believing there would be a "substantial correction" in housing, real estate and junk bonds.

Many of its positions moved against Mooring Intrepid for the first eight months or so, but they eventually recovered, with the fund gaining 86% this year and 216% since its inception in March 2007. But the risks were substantial, and had the housing correction taken longer to get under way, Mooring Intrepid might have become unmoored.

"

Investors have been quite pleased because we've done so well," says Jacquemin. They were also "made very aware that it was a high-risk, high-volatility kind of fund, that if we were right it stood to make substantial gains, but that we could be wrong, or we could be right way too early, and lose most of our equity on carry costs."

Ultimately, there will surely be hedge funds left when the dust settles from the economic crisis of 2008, but, as with all industries, only the strong will survive. Those who do likely will operate on a smaller playing field with new rules and stricter refs.

"Literally, in the last year, all the definitions have changed," says Minard. "Portable alpha doesn't mean anything anymore. 130/30 is dead."