THE HUMBLING OF HEDGE FUNDS

THE HUMBLING OF HEDGE FUNDS

The arrest of Bernard L. Madoff, the financier who allegedly ran a giant Ponzi scheme, could mark the end of the hedge fund era.

Hedge funds already had been in a downward spiral as markets cratered and investors pulled money out. Even so, some players remained optimistic that investors would rescind outstanding redemption notices if stocks and bonds stabilized. But the Madoff mess, in which losses could exceed $20 billion, has dimmed those hopes. "This is a black eye for hedge funds," says Carl R. Hall, a money manager at Choate Investment Advisors, which handles $2.5 billion for wealthy individuals.

The industry's problems are twofold. First, there's the immediate fear that the scandal will sink some prominent hedge funds that invested with Madoff. Consider another alleged scam involving Minnesota businessman Tom Petters, who federal authorities claim recently fleeced five hedge funds of $3.5 billion. One, the $1.5 billion Lancelot Investment Management, filed for bankruptcy in October as a result.

The longer-term fallout could be more damaging. Hundreds of hedge fund managers suffering double-digit drops have clung to the notion that the chaos would subside. In a move to stem losses, at least 75 hedge funds, including Citadel Investment Management, Whitebox Advisors, and GLG Partners, have blocked investors from pulling out money. Many struggling funds will have little choice but to shut their doors entirely. The industry's assets, down to $1.5 trillion from a high of $2 trillion in early 2008, could fall to less than $1 trillion by the end of 2009.

So-called funds of hedge funds, which buy stakes in multiple hedge funds, will be among the hardest hit. They were supposed to be safer, offering a diversified investment that aimed to reduce the risk of a blowup in any single portfolio. Fund-of-funds managers also assured clients that they deeply researched the underlying hedge funds. Many funds of funds--including ones at Man Group and Banco Santander--plowed money into Madoff's firm and got burned. That's damaging the main sales pitch for funds of funds.

Already, some big institutions are reconsidering certain investments. Michael Travaglini, executive director of Massachusetts' $39 billion state pension fund, is reviewing Austin Capital Management. The fund of funds sunk $14 million of the pension's money into Madoff's portfolio: "We need to understand whether their due diligence process is sufficient for our purposes."

Banks that lent money to funds of funds may also rethink their relationships. France's BNP Paribas, which provides credit to funds of funds, says it could take a $470 million hit from the Madoff mess. All of this is raising serious doubts about the viability of funds of funds, which account for roughly 43% of the industry's assets.

The ramifications of the Madoff disaster could be felt for years. Without two huge sources of ready money--funds of funds and bank credit lines--hedge fund managers will find it more difficult to produce outsize returns. As expectations come down, fees will have to follow. In the end, hedge funds may look more like they did in the 1980s, when portfolios were designed to modestly outpace the market. "For a while, it seemed everyone could open up a hedge fund," says Hall. "But there's no such thing as a free lunch."