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Hedge Funds Losing Money, But Keeping Clients

NEW YORK (Reuters) – Hedge funds are losing money but that doesn't mean the $1.8 trillion industry is losing clients — yet.

Pension funds and endowments, whose big bets on hedge funds helped double industry assets in the last five years, are sticking with loosely regulated hedge funds for now, even as returns sag.

But they are also paying extra close attention to who is up and who is down, moving faster than ever in rotating among the industry's estimated 10,000 individual funds and firing losers before they can do real damage to a portfolio.

“Yes, big investors are getting nervous about losses but they are not reducing exposure to the bucket we call alternatives as a whole,” said Stephen Moseley, president of private equity firm StepStone Group LLC, at the Reuters Hedge Fund and Private Equity Fund Summit in New York this week. StepStone works with large pension funds.

Jane Buchan, who runs Pacific Alternative Asset Management (PAAMCO), a $10 billion fund of funds that selects hedge funds for pension funds and endowments, agreed. “People may be pulling out of managers but they are not shutting down programs.”

The shock of losing big when hedge funds Amaranth Advisors and Sowood Capital collapsed in 2006 and 2007, respectively, raised red flags for fund trustees to more closely monitor hedge funds.

This year their worries are bigger still.

In the first quarter the average hedge fund lost 4.4 percent, according to BarclayHedge, marking the industry's worst first quarter ever. 

But losses in the stock market are even deeper, and trustees are hoping hedge funds can make up the declines that mounting job losses, a deepening housing crisis and fears the U.S. economy is already in recession are dealing their portfolios.

So industry experts say money is still flowing into hedge funds but with more restrictions attached.”The standard of due diligence they are applying is greater and people are generally more cautious and deliberate in their decision making,” StepStone's Moseley said.

The $52 billion Massachusetts state pension fund, whose assets are off from $53.7 billion earlier this year, decided to stick with funds of funds like Buchan's PAAMCO instead of trying to make hedge fund manager selections alone.

Michael Travaglini, the fund's executive director, told the Reuters Summit he is happy to pay a middleman's extra fees for the peace of mind that hedge fund experts will be policing his portfolio of 140 hedge fund managers better than his staff of 23 ever could.

At Bank of America, which puts certain clients' money with roughly 100 individual managers, David Bailin, who oversees the alternative investment unit, said he removed 15 percent of them from his roster last year. “That level was up in 2007 from 2006,” he said at the summit.

Bailin's team got out of so-called quant funds which rely on computer models to pick investments and have delivered uneven returns recently.

Losing money is not good. But losing more money than you are supposed to is very bad,” Bailin said, adding his team might fire someone for drifting from their style in the way Amaranth Advisors did before it collapsed. Personnel shifts and a major loss of capital are also potential red flags for his team.

Indeed, investors are so aggressive in monitoring their funds now that many get out at the first rumors of potential trouble. “There is an attitude of shoot first and ask questions later,” PAAMCO's Buchan said as redemption notices piled up.

Hedge fund manager D.B. Zwirn & Co, for example, was flooded with redemption notices this year, forcing it to close down one of its portfolios.

But that money usually then goes to another hedge fund manager or even moves into real estate, for example, within the alternative investment sector, people said.

Still as money is being rotated around, many investors expect hundreds of hedge funds to go out of business this year, falling victim both to banks' stingier lending practices and investors' demands for their money back.

Already the pace of hedge funds closing is higher this year than in previous years, industry experts said, with managers who oversaw some $3.9 billion out of business in the first quarter.

Overall though, winnowing the number of fund managers might not be a bad thing, industry experts agreed. “I am not worried about the health of this industry,” Bailin said.

By Svea Herbst-Ba