Hedge Funds Concede Errors, Profess Optimism After Worst Losses

By Saijel Kishan and Katherine Burton

Oct. 14 (Bloomberg) -- Hedge fund managers, after enduring the industry's worst month in a decade, are seeking to explain to investors what went wrong and what they are doing about it.

``We clearly underestimated several things, most importantly the tsunami of redemptions that are being delivered to hedge funds as investors line up to get out of these funds as well as record outflows from equity mutual funds,'' Jeffrey Gendell, who runs Greenwich, Connecticut-based Tontine Associates LLC, wrote in an Oct. 1 letter to clients.

``I am not a nervous person by nature, but should have been under the circumstances,'' wrote Gendell, whose Tontine Partners LP fund plunged 59 percent in September, leaving it down 67 percent for the year, according to investors. Gendell, 49, had expected shares of steel, engineering, airline and chemical companies to appreciate because of falling oil prices. Instead they plummeted.

Hedge funds, which endeavor to make money whether markets rise or fall, lost an average of 4.7 percent in September, the biggest monthly decline since August 1998, according to data compiled by Hedge Fund Research Inc. Funds fell 17 percent this year through Oct. 9, compared with the 38 percent decline by the MSCI World Index of stocks. It was the worst performance by the lightly regulated private pools of capital since the Chicago- based firm began collecting data.

Failure Rate

As much as almost a third of hedge funds may close in the next two years, according to a Sept. 29 report by Zurich-based analysts at Credit Suisse Group AG. There were about 3,100 hedge funds that managed a combined $1.9 trillion as of June 30, according to Hedge Fund Research. This year's investment losses mean many funds won't be able to collect performance fees, usually 20 percent of gains, while management fees, usually 2 percent of assets, will shrink.

Managers have been selling assets, both to raise cash for what they expect to be a surge in year-end redemption requests and to preserve capital as market volatility has risen to record levels. The Standard & Poor's 500 Index yesterday rebounded from its worst week in 75 years with an 11.6 percent advance.

David Slager, manager of the Atticus European Fund, told investors that more than 50 percent of his fund is now in cash or U.S. Treasuries after he lost 43.5 percent so far this year.

``I believe it is prudent to maintain our critical focus on capital preservation and liquidity,'' he wrote in a letter sent Oct. 1.

Slager, 36, who is vice chairman of New York-based Atticus Capital LP, told investors that his holdings are now skewed toward stocks that will fall, while in July, his bets were mostly bullish because he had anticipated only a mild economic slowdown in the U.S.

Glad It's Done

``While in hindsight I wish I had made the decision to sell sooner, I am glad that it is now done,'' he wrote. He said he would start buying again only after a ``climactic selloff'' or when he deems that credit markets have stabilized.

Slager declined to comment.

David Einhorn, who runs New York-based Greenlight Capital LLC, said external forces were partly to blame for the 17 percent drop in his three funds in September.

While he and his team made mistakes, ``we believe that our portfolio management has been reasonable,'' Einhorn wrote in an Oct. 1 letter to clients.

Einhorn, 39, pointed to the U.S. Securities and Exchange Commission's Sept. 18 ban on short sales of financial stocks for some of the losses in the month. The ban, which expired Oct. 9, eventually included about 15 percent of the companies in the Standard & Poor's 500 Index.

Caught Short

In a short sale, investors sell borrowed stock in hopes of repurchasing it later at a lower price and pocketing the difference. A long position is one that an investor holds in expectation it will rise.

After the ban went into place, the shorts recovered much more than the longs, he wrote, ``especially the financial shorts abundant in our portfolio.''

Einhorn, who earlier this year was vocal in this view that shares of now-bankrupt Lehman Brothers Holdings Inc. would tumble, said he planned to hold onto the short positions in financial companies ``for a good deal of time (providing there aren't additional extraordinary legal changes) until they begin to trade in a normal market environment again.''

In the third quarter, Einhorn's three funds lost about 15 percent, one percentage point of which came from stocks he had shorted. Nine companies Einhorn held long, including French chemical-maker Arkema SA, French bank Natixis SA and Houston- based oil and gas producer Helix Energy Solutions Group Inc., each contributed more than one percentage point to the quarterly drop.

Playing Defense

Einhorn told investors his funds are more conservatively invested than ever. While almost three-quarters of assets, including leverage, are long, he has offset those holdings with short sales that bring the net to 9 percent. Einhorn declined to comment.

Gendell, who also runs a stock fund that buys and sells banks an other financial-services shares, said he's expanding investments in regional banks, ``which we think will have a remarkable period of earnings growth over the next two to three years.'' His Tontine Financial Partners LP fund was up in September, he told investors in his letter, without providing details.

Tontine is allowing investors to add to their investments, without adding to the length of time their money must remain with the funds, ``for those who seek to take advantage of this decline.'' Gendell declined to comment.

Greenlight is also opening its funds to a limited amount of new investments on Nov. 1 ``in order to take advantage of the investment opportunities we believe will be available in the coming year.''

To contact the reporters on this story: Saijel Kishan in New York at skishan@bloomberg.net; Katherine Burton in New York at kburton@bloomberg.net