From the October 2008 issue of Investment Advisor • Subscribe!

More Hedge Fund Closures Likely

The closure of Ospraie Manage-ment LLC's flagship hedge fund is likely to be the first of several such failures, as a slump in commodities and a spike in financial stocks catch out funds with hard-to-sell positions.

Five years of soaring commodity prices have encouraged a flood of investor assets and a raft of new hedge funds that have sought investment opportunities in an increasingly crowded sector. However, the recent setback in commodity and energy prices, driven by concerns that demand for resources will suffer as economic growth slows, has seen many managers take substantial hits.

Those in illiquid positions face a big headache as nervous investors look to withdraw their money at the first opportunity.

"I think there will be more problems," said one manager who requested anonymity in order to speak candidly. "It will be an issue for hedge funds with quarterly redemptions who have gone into illiquid positions. It was not too dissimilar to the dot.com boom, where larger players bought a lot of smaller companies without too carefully considering them, (although) there is underlying value in the commodity and energy sector."

In early September, Ospraie said it could take up to three years to return the most illiquid 20% of its assets to investors. Performance issues have already been seen at RAB Capital's previously top-performing hedge fund RAB Special Situations, which invests in small-cap mining stocks. These tend to be harder to sell than shares of larger companies.

"It was pretty much a one-way bet in the second half of last year," Randal Goldsmith, director of fund research at S&P Fund Services, told Reuters. "We're now seeing sharp corrections in commodities....It can be very damaging. There are hedge funds that have taken significant positions in commodities and it if did prove to be a bear market a lot of hedge funds would be in trouble."

Hedge funds that have been simultaneously betting on rising commodity prices and falling financials as the credit crisis unfolds have been hit particularly hard. The FTSE All Share Mining index, which has rocketed in recent years, fell 21.7% from June 30 to September 2. Meanwhile the FTSE All Share Banks index rose 12.4% as investors snapped up cheap stocks.

Even managed futures funds, whose bet on trends in global futures markets has been one of the star hedge fund strategies so far this year, have been hit by the sharp reversal to which they are traditionally slower to react, and subsequent volatility in these sectors.

"Stop losses are widely used as risk controls (by managed futures)," said Goldsmith. "This works great if commodities or equities go in one direction, but if they go back up (it doesn't work so well). Volatility kills any trend-following strategy."

Despite the sharp losses, hedge fund managers remain divided about whether or not this is a blip or the start of a longer fall. "We haven't found unanimity among funds-of-hedge-funds as to whether this has come to an end is or just a correction," said Goldsmith.

However, some believe markets have reached a turning point and out-of-favor sectors, such as retail, could be due a rebound.

"The key relative call from here is clearly consumer versus commodity," said Cazenove hedge fund managers Chris Rice and Steve Cordell in a note to investors. "For the last five years it has been a one-way bet, but now the tide is turning....In twelve months the chances of [British fashion retailer] Next outperforming [mining group] BHP Billiton are very high."

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