Lessons Learned From the Hedge Fund Crisis

OKLAHOMA CITY -- Robert Lawton no longer manages his own hedge fund.

Like so many others in the battered industry, Lawton exited the business as the stock market crashed last year. He fared better than most, however, since he simply agreed to sell his firm and expects it to keep thriving.

He still invests money for a living, too, although he now works as an old-fashioned stock broker. Lawton no longer calls himself a "hedge fund manager," a title that now carries enormous pressure and a hefty dose of taint, though he shares their newfound caution.

Lawton has abandoned the one high-risk strategy that actually worked wonders during the market plunge last year. Reversing a decade-long practice, he finally stopped shorting stocks that seem overvalued and destined for big losses. Since late November, when the market fell to its lowest level in years, he has stuck with bullish bets on stocks that look ripe for sudden gains.

In today's brutal market, however, Lawton often rushes to cash in. He wound up taking profits on Bank of America ( BAC), for example, only to buy the stock at a higher price so he could make money on it once again.

"I've been kind of spinning in and out of stuff," Lawton admits. "I have sort of mixed feelings about that. I used to work with a guy who had this sign that said, 'Traders die broke,'" he explains. "And I've lost tons of money doing all the wrong things, including trading. But there are so many opportunities on the long side that I feel good taking my profits and walking away."

Lawton officially shifted roles in late November, adding veteran insurance executive Andrew Carr as a client, and has been reporting sizable gains ever since.

"My biggest fear is that I'll wake up and find out that Lawton is a mirage and this is all a figment of my imagination," Carr recently said in an interview with TheStreet.com. But "so far, he's very real."

Carr keeps pinching himself for a reason. For years, he placed his trust -- and a big chunk of his fortune -- in a well-established fund that he says now reminds him of Bernard Madoff's infamous Ponzi scheme.

Madoff operated an elite hedge fund that consistently reported impressive gains until it fell apart late last year. His clients, some of them the richest and smartest investors in the world, stand to potentially lose billions.

Publicly traded hedge funds, already hurt by their own bets, have suffered from the fallout. Once $30 high fliers, Blackstone ( BX) and Fortress ( FIG) now trade at less than $5 apiece.

The past year brought enough pain, in fact, to reshape the entire industry. It killed some hedge funds entirely and weakened many of the once-mighty firms that still remain. Ultimately, it left the survivors with fewer clients investing fewer dollars in a market that promises fewer returns.

It also taught hedge funds, and their clients, a lesson.

"It made investors completely reassess their notions of money management, especially the notion that they can place money with people who somehow get unique information that gives them a performance edge," says an industry veteran employed by one of the nation's largest hedge funds. "I think that the investor community -- the big endowments, the large asset managers, the alternative investment groups -- will start placing their money with fewer managers and sticking to those with seasoned track records."

Meanwhile, he adds, "Their clients are already telling them: 'No more chasing the hedge fund guys. No more fancy stuff.'"

Some veteran hedge fund managers actually welcome the industry shakeout.

They felt crowded by all the young college graduates who kept bypassing careers in traditional fields, such as law and medicine, in order to pursue big fortunes on Wall Street. At the same time, they watched their own specialized profession turn into a giant game of follow-the-leader -- long on people, but short on ideas -- that delivered few clear winners in the end.

"Too many hedge funds were in the same stocks, doing the same things, so their returns were too correlated," one veteran insider says. "Now, everyone's rethinking their entire business model. It's almost like going back to the basics."

If anything, the industry has lost its original stomach for risk. Right now, many hedge funds are sitting on huge piles of cash because they simply can't afford to put that money to work. They fielded massive calls for cash at the end of the last quarter, as their clients rushed to close out their dwindling accounts, and some funds wound up liquidating promising investments during sharp market selloffs as a result. By establishing generous cash positions in advance, they aim to be better prepared for those redemptions this time around.

Indeed, some experts predict, hedge funds could play it safe, and ultimately dampen the market, for a while.

"Hedge funds must make money this year," says Sheryl Skolnick, senior vice president of CRT Capital Group, which shuttered its own hedge fund last year. "They'll take their gains as they can. They'll pick their entry point, pick their exit point, make their money and go home. So while the market may go up, it may not go up with any conviction."

Skolnick has described Lawton's strategy to a tee. As Lawton's new client, Carr feels pretty good, as well. For the first time in recent memory, he's actually making money again.

"I gave him a modest amount of money, and a week or two later it was worth 20% more," Carr says. "He actually made money for me. And he calls me every other day."

Lawton admits that his clients, especially those burned in the past, might grow nervous once again. In fact, he keeps waiting for some of them to demand their money so that they can see for themselves that it is real. However, he has received no such requests.

Fredric E. Russell, a traditional money manager based in Oklahoma, suffered just one client redemption even though his fund lost serious ground last year. In fact, Russell barely fielded any phone calls from investors worried about the deep market plunge that interrupted his firm's long winning streak.

Thanks to his meticulous research, and his deep aversion to risk, Russell feels that he has won his clients' lasting trust.

Although he grew up in Manhattan and attended some of the same schools favored by Wall Street's elite, Russell never actually ran with the hedge fund crowd. He followed their lead one time, piling into Tulsa-based Williams ( WMB) during the energy-trading craze, but wound up paying a high price after Enron's notorious collapse. He has otherwise stuck with his own research, focusing on no more than 20 companies at a time, throughout his career.

"We spend days, sometimes weeks, researching investments," Russell explains. "We try to reduce our risk by taking positions in companies that we understand."

While doing homework on his current favorite, Florida-based Sun Hydraulics ( SNHY), Russell flew out to the company's headquarters and spent two days meeting with its top leaders. He then followed the lead of his real idol, Warren Buffett, by penning an insightful letter to his clients that cleverly reflected the findings of his trip.

Russell performs similar due diligence on his fund's other investments, regularly highlighting his favorites in colorful letters that have become a trademark of his firm.

That strategy appears to work. Unlike many hedge funds, which saw their client lists shrivel during last year's market crash, Russell actually attracted new customers, more than offsetting the one he lost, despite the 29.4% decline recorded by his firm.

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