Nine out of 10 long/short hedge funds fall below their watermark

CSFB/Tremont survey spells bad news for industry as most hedge funds, globally, show big shortfalls

More than 90% of long/short portfolios covered by CSFB/Tremont were sitting below their watermarks towards the end of 2002.

Low and volatile returns over the past year have left hedge fund managers across most strategies trying to maintain clients under increasingly tight margins.

As most hedge funds impose high watermarks to their 20% performance fees, they cannot collect these charges from investors until they have made good previous shortfalls.

This has led to a rise in the annual management fees on many portfolios, up from the typical 1%pa management charge towards 1.5% and 2% in some cases.

According to data from CSFB/Tremont, of the funds below their high watermarks as of 31 October, emerging market portfolios were the worst off. They lagged on average 22.6% below the mark, while long/short funds had to make up 17.3% before they could start charging performance fees.

Oliver Schupp, president at CSFB/Tremont, said while remaining open underwater may work for large funds that can still afford to run a business while sustaining a critical mass to keep making meaningful investments, smaller sub-watermark funds will struggle.

'There is often a decrease in assets that comes with a decrease in performance. If you were $500m and went down to $80m or $120m, it is unlikely that strategy will remain successful and I would expect them to close down shop, but if you can keep your assets and your investors really believe in you, you may be okay.'

Schupp said he expected to see more funds blow-up and then reopen with a new baseline for their fees.

'If you are a long-standing investor you may get a break on some of the fees if they do this,' he noted.

Schupp said the close-then-reopen strategy may be 'quite sneaky,' but its appropriateness depends more on whether the manager can deliver good returns after re-opening.

'A fund that can do that and still has a lot of assets is most likely a fund that made enormous returns in the late 1990s. An investor would stay if he has already had good returns otherwise there is no reason to stay when you are 30% down,' he said.

Schupp added the shock of decreases in income from performance fees has been offset by some funds increasing management and annual fees from a 1% annual management and 20% performance fee average in 1995, to 1.5% and 20% being now the industry average.

'I believe there is a lot of hype about hedge funds and not many deliver what is expected,' Schupp said.

Schupp said if his belief proves true, that most investors invested in hedge funds by re-allocating their long equity money, the outlook for hedge fund inflows does not bode well for the industry when long-only markets resume growing.

Zeeshan Kanji, senior manager at Ernst & Young within the hedge fund practice, said it is a difficult situation because investors are there on the basis of achieving returns. 'Increasing the asset base is the most obvious solution but the manager is in a Catch 22. One way to keep people on board or even attract new investment might be to set up a new fund. Arbitrage strategies have been doing rather badly recently so a manager might open say, a macro fund, and offer free redemptions to his investors, giving them a new start. It is risky but it could work.'

He also said new funds considering a launch could write a clause in their contracts similar to Schupp's 'close-then-open' strategy, which could mitigate any renegotiation of the high watermark. 'New funds could state the high watermark is readjustable after X number of years, so after every three years, it could return to the original level. I do not think cost cutting is the answer as most costs are long-term commitments like leases and so on. The only flexible costs are in salaries and it is difficult to shave off costs in technology.'