An Industry Still in Crisis

More pain to come, more change in sight

Originally published in the August 2009 issue

The financial turmoil in late 2008 wreaked havoc on hedge funds’ performance and their businesses. Although the industry’s assets under management soared in the first half of the year, peaking at nearly $2 trillion, they declined by a quarter in the second half of the year. An industry shakeout has ensued, with a record number of hedge funds closing. One fund manager we interviewed called this “the dot-com bust” for hedge funds. But just as the dot-com bust hardly spelled the end of Internet business, the challenges of the past 18 months will not cause the collapse of the hedge fund industry.

Negative returns account for two-thirds of the drop in assets
Poor hedge fund performance accounted for two-thirds of the decline in hedge fund assets under management in 2008 (see Fig. 1). The Hedge Fund Research Index, a broad measure of industry performance, fell 18% in 2008. Nearly all major hedge fund strategies – referred to by their shorthand names as equity hedge, event-driven, and relative value – posted negative returns. The one exception was the category known as macro strategies, which was up 7% for the year.


At the writing of this report, hedge funds are beginning to recover from the losses of 2008. Through the first quarter of 2009, aggregate industry returns were up 0.5%, and the best-performing strategy (relative value) generated gains of 4.7%. By the end of May, an index of hedge fund returns was up 9.4% for the year. Many individual funds, including some of the best known, have reported double-digit gains for the year to date.

Investors seeking liquidity made unprecedented withdrawals
For the first time in hedge fund history, investors made major net withdrawals in 2008. The net asset outflow totalled $183 billion from the peak in the second quarter through the fourth quarter, and an additional $103 billion was withdrawn by investors in the first quarter of 2009 (see Fig. 1). This is equivalent to about half of the net new money that flowed into hedge funds since 2003. Asset outflows would have been even more severe in 2008 if not for the fact that many hedge funds temporarily stopped or limited investors’ withdrawals to prevent the hedge fund version of a bank run.

Wealthy individuals proved to be the most fickle hedge fund investors. One report finds that 80% of withdrawals were made by high-net-worth individuals, while pension funds increased their investments over the year. If accurate, this would imply that wealthy investors reduced their hedge fund investments by 20% – in addition to losses on their remaining hedge fund assets. The financial crisis is thus accelerating a shift in the hedge fund investor base that was already under way.

Up to 30% of remaining hedge funds may be at risk of liquidation
A record number of hedge funds closed in 2008, with the total falling by 11% (see Fig. 2). This caused the industry to become slightly more concentrated: 73% of remaining assets under management are controlled by approximately 200 hedge fund firms, each with assets greater than $1 billion.


Our analysis suggests that more hedge funds may close in 2009 because their assets under management have fallen far below their peak, or high-water mark. Using a database with 1,000 hedge funds, we found that 30% – representing 35% of assets under management – will not regain their peak for at least two years if they continue to earn their past average returns. Most of these funds will not earn the 20% or more performance fees over this period, so managers may choose to shut down these funds rather than operate solely for the 2% management fee. Some of these managers, however, may start new funds. For hedge funds with strong track records, investors may be willing to renegotiate more favourable performance fee structures to increase incentives. But newer funds with a shorter history of performance, or those that have not performed well, could become casualties of the industry shakeout.

Clearer liquidity terms
One lesson vividly illustrated by the financial crisis was the extent to which many investors and fund managers ignored or discounted liquidity risk. Hedge funds’ liquidity profiles vary widely. A fund’s “liquidity period” is the time it takes to liquidate its assets. Some hedge funds have liquidity periods of a month or less; others measure liquidity periods in quarters or years. In principle, the liquidity period should be less than the redemption period, so managers have plenty of time to raise sufficient cash to satisfy redemption requests. However, the opposite situation has become very common, with investments shifting toward more illiquid assets but with redemption policies staying the same. Many fund managers were forced to limit redemption requests at the end of 2008 either because they didn’t have sufficient liquid positions to satisfy all requests or because they did not want to sell into a falling market. Going forward, investors are likely to pay more attention to hedge funds’ liquidity structure and redemption policies. Traditionally, investors with longer lockup periods have been rewarded with lower fees. Two hedge funds managers with whom we spoke have explicitly created longer-term, less liquid investment strategies. In return, managers have altered the fee structure so all performance fees are paid at the end of the investment period, as in a private equity fund.

Assets under management may not regain peak over the next five years
The hedge fund industry has continued to shrink in 2009, but we expect it to recover and resume growth after that. Given the uncertainties in the global economic and financial outlook, we model hedge fund growth in four proprietary macroeconomic scenarios developed by McKinsey & Company and Oxford Economics. Fig. 3 shows a stylized version of the path of global GDP over time in each scenario. For simplicity, we focus on three of the scenarios:

Macroeconomic scenario assumptions

Scenario 1: quick fix
• More moderate economic recession, with GDP growth resuming in late 2009
• Investor portfolio recovery within three years
• Increased investor commitment to the hedge fund asset class, with allocation returning to peak 2007 levels, or 2.1% on average across investors

Scenario 2: battered, but resilient
• Severe economic recession, with GDP growth resuming in mid-2010
• Investor portfolio recovery after four to five years
• Continued investor commitment to the hedge fund asset class, with allocation remaining at its 2003-08 average, or 1.6% on average across investors

Scenario 4: long freeze
• Extremely severe economic recession, with GDP growth not resuming until 2011
• Investor portfolios do not fully recover within the next five years
• Reduced investor interest in the hedge fund asset class, with allocation remaining at pre-2003 levels, or 1% for all investors


We highlight Scenario 2 as the base case because it is viewed as the most likely to occur by a plurality, 39%, of respondents to the McKinsey Quarterly executive survey (June 2009). In Scenario 2, in which the global recession lasts through mid-2010, hedge fund assets under management continue to decline through 2009. Then, when growth picks up, it is at a slower pace than from 2000 through 2007. As a result, hedge fund assets under management reach $1.5 trillion by 2013 – less than in our earlier projections, but still a significant force in financial markets.

Future growth depends on the pace of macroeconomic recovery
Hedge funds have continued to lose assets in 2009 as lockup periods expire and investors withdraw funds. One survey of hedge fund investors finds that most expect net withdrawals in 2009 to exceed those in 2008 as investors seek liquidity. In addition, hedge funds well below their high-water mark are likely to exit. All in all, hedge fund industry assets under management in 2009 could shrink to between $900 billion and $1.2 trillion. Beyond 2009, each of the scenarios envisions unique GDP and equity market trajectories, which in turn determine the size of investor portfolios. In the investor universe, we include pension funds, insurance companies, sovereign wealth funds, and high-net-worth individuals. In 2007, these investors had $91 trillion in assets. By the end of 2008, their wealth had shrunk to an estimated $75 trillion. Given the magnitude of this decline, it will take some time for their assets to recover. In Scenario 2, investor portfolios will require four to five years to return to 2007 levels. In modelling future growth of hedge funds, we also include assumptions about investor allocations to hedge funds in each scenario. In Scenario 2, we assume that investors maintain their pre-crisis allocation to hedge funds. This is consistent with recent investor surveys, which suggest most investors will hold their long-term percentage allocation to hedge funds constant.

In the base-case scenario, assets in 2013 remain below their mid-2008 peak. In Scenario 2, the base case, hedge fund industry assets under management grow to approximately $1.5 trillion by 2013, well below their peak in mid-2008 (Fig. 4). After declining further in 2009, hedge fund assets grow at a compound annual rate of 10% from 2010 through 2013, compared with their 23% annual growth rate from 2003 to 2007. The industry’s growth is constrained by a severe global recession, with recovery not beginning until 2010, and by no change in investor allocations to hedge funds.


In Scenario 1, which envisions a quicker economic recovery, hedge fund assets could grow to $2.4 trillion by 2013 – or 26% above their 2008 peak. This outcome would depend on a rapid economic recovery starting at the end of 2009, with continued GDP growth through 2013. Equity market recovery would follow, with global equities appreciating faster than 10% per year through 2013. Moreover, this scenario assumes that investors’ allocation to hedge funds, as a share of their portfolios, would return to the peak level reached in mid-2008. In Scenario 4, which assumes a longer recession, hedge fund industry assets could shrink further, falling to $800 billion in 2013, or nearly 60% below their peak. This outcome would reflect continuing decline or stagnation in the global economy with no substantial growth in investor portfolio assets.

Moreover, this scenario assumes a reduction in investor allocations to hedge funds by about one-third, or back to levels not seen since 2003. While investors have not expressed any intention of retreating from hedge funds to this extent, new regulations limiting allocations by public institutional investors such as pension funds would have a similar effect.

Hedge funds experienced unprecedented growth from 2002 through 2007 – a time when they went from being niche investment vehicles to dominant players in many corners of the financial markets. But now a shakeout is under way in which many funds are closing and wealthy individual investors are retrenching. The next several years will challenge the industry as credit remains tight and investors have less wealth to allocate. But we expect the hedge fund industry to recover. Funds with strong track records of good performance will survive – and may gain scale and thrive. Ultimately, a more consolidated, mature industry will emerge.

The numbers really are too good to be true

Any analysis of hedge fund performance is beset by data limitations. No database has full records of the performance of all hedge funds, and the data in even the best databases contain biases that increase reported returns. These include selection bias, which arises because database inclusion is voluntary; survivorship bias, which occurs because funds that were unsuccessful and went out of business are not contained in most hedge fund databases; backfill bias, which arises because once funds register, databases include return histories from before the date of fund inclusion, coming from the period when the fund amassed a track record good enough to merit inclusion in a database; and, finally, liquidation bias, which arises because managers cease reporting returns before final fund liquidation. While researchers do not have good measures of the net effect of all these biases, some estimate that together survivorship and backfill biases may inflate reports of average hedge fund returns by as much as 4%.