Will Year-End Redemptions Kill Hedge Funds?
Investors fled hedge funds in droves in the third quarter, withdrawing a record $31.7 billion according to Hedge Fund Research Inc., and by now managers know what their end-of-year redemption requests look like, even if they're not telling. Many have already raised significant cash by selling off holdings. "But it's really a guessing game as to whether managers have created all the liquidity they need, or whether there will be massive selling through year-end," says Chris Jackson, manager of a fund of hedge funds and president of SFG Asset Advisors in San Francisco.

Some attribute the stock market's October free fall to hedge fund selling and believe the same dynamics could operate this month. Matthew Adams, director of investments at Mission Wealth Management in Santa Barbara, Calif., explains the conventional wisdom: "Hedge funds are being forced to liquidate positions not only because of investor redemptions, but also because of difficulty obtaining leverage. The result is selling upon selling upon selling, driving the market lower."

Not everyone shares this perspective, however. "Most equity long-short managers were not highly leveraged in October and hadn't been for several months," says Sol Waksman, president of BarclayHedge, a hedge fund performance tracker. Thomas Whelan, president of Greenwich Alternative Investments, a hedge fund advisory firm in Stamford, Conn., believes it wasn't hedge fund selling alone that pummeled stocks, but also tax selling by mutual funds ahead of their October 31 tax year's end, coupled with a large amount of pension plan equity unwinding in October.

For December, Whelan expects a slew of market participants, including hedge funds, to dump stocks as they re-examine the place of equities in their portfolios. Jackson suggests that liquidation pressures could continue into 2009 because some hedge funds have temporarily stopped accepting redemption requests, creating a backlog.

From the perspective of the $1.7 trillion (and falling) hedge fund industry, heavy withdrawals represent dissatisfaction with the product. "Many hedge funds didn't have much hedge when it counted," quips Jackson. Underachievers, including funds of funds, are now facing potentially large-scale redemptions and unfavorable economics where money management fees levied on dramatically fewer assets may not adequately cover fund operating costs, much less the manager's lifestyle.

Yet that's not the only reason hundreds of portfolios may soon vanish. Funds with large investment losses must rebound in order for the manager to earn his juicy performance interest, a potential jackpot that may well be his prime motivation for running the fund, says advisor Richard Lee, president of Lee Financial Corp. in Dallas. Managers may be tempted to close down beaten-up, under-sized funds, then turn around and start up new ones. "That way they don't have to recover the high watermark," says Lee.

What's an advisor to do? "We've told clients, 'If you think a run on hedge funds is a plausible scenario, get out as soon as you can because that's something you can't really protect against,'" reports Erin Scannell, the managing partner of Johnson, Scannell and Associates in Bellevue, Wash.
Those who don't flee need to take a good, hard look at their funds. Have the managers picked good securities, or dogs? Made smart decisions, or panicked? "If they're down a lot, in this environment you have to decide whether it's a manager issue or a market issue," Lee says. "You also want to see whether there is a fundamental disconnect between what the managers said they would do and what they're actually doing."

In the meantime, Lee is adding significantly to stakes in the distressed debt area, which focuses on companies facing extreme financial difficulty. "That should be one of the most opportunistic parts of the hedge fund market right now," he says.

Whatever hiccup-or heart attack-year-end redemptions cause, the industry is learning, Lee says. "Managers are rethinking how to structure hedge fund liquidity so that they can operate in a more orderly fashion."

Whither Commodities?
What do you get when you put a bunch of commodities players in a room? A mix of short-term gloom and long-term boom. At least that's what the mood was like at last month's "Inside Commodities" conference at the New York Stock Exchange. The massive correction in most commodities since the sector's summer peak hasn't dented the underlying supply-and-demand fundamentals in this area. These fundamentals should propel the sector during the long haul, said various speakers, but don't bank on a quick recovery.

"Over the next six to nine months, there's the serious likelihood of a collapse in the commodities market," said John Brynjolfsson, managing director at Armored Wolf, a hedge fund in Aliso Viejo, Calif. He noted that commodities have taken a hit with the sharp slowdown in China's economic growth rate. He termed one forecast for 5.8% growth in next year's gross domestic product as the equivalent of a depression for China. "That means the U.S. financial crisis will be magnified by the collapse in broader global demand."

Brynjolfsson recommended avoiding industrial metals and energy-i.e., things based on cyclical economic strength. Peter Schiff, president of Euro Pacific Capital in Darien, Conn., said the world will soon tire of lending money to the U.S. for Americans to squander, and will instead reinvest more in their own economies. That will ignite domestic consumption in big-ticket items that will raise living standards in developing nations. "That's where I think the real lift in commodities prices will come from," Schiff said.

Noted commodities bull Jim Rogers gave a far-ranging and entertaining talk on why China is the future, why long-term U.S. bonds aren't worth a lick, and why commodities are in a long-term secular bull market despite the recent stumbles. These recent setbacks, he believes, are due largely to massive forced selling by hedge funds and other investors.

Rogers said stocks periodically go through long sideways markets, and we're eight years into the current sideways cycle. At the same time, Rogers believes a concurrent commodities bull market cycle began in 1999 and has been fueled by severe supply-and-demand imbalances that should continue for the foreseeable future. He noted there's an inverse relationship between stocks and commodities-higher commodity prices mean higher costs and lower profits for companies, which hurts stocks.

Based on three long, bullish periods for commodities in the 20th century, he said the average commodities bull market lasts about 18 years. "I'm not saying that'll be the case now," he said. "I'm just talking history." Rogers said he's buying mainly shares of Chinese and Taiwanese companies and the Chinese currency, along with agricultural commodities, through his own index fund. "Ag is very cheap on a historical basis," he says.

Jeffrey Saut, chief investment strategist at Raymond James & Associates, noted growing wealth in developing countries boosts demand for animal protein, which means greater demand for grains to feed livestock. He said global food production is expected to rise twofold by 2050. "There'll be bumps in the road," Saut noted, "but I think it's an unstoppable trend."

Saut said he trimmed his commodities positions by 30% to 40% in late 2007 when the sector got too hot, but says he likes water and fertilizer companies. "I'm bullish on Vietnam because it has a lot of water and arable land," he said. Saut also liked ADM's convertible preferreds.
One issue bandied about is whether commodities are a true asset class. But Philippe El-Asmar, a managing director at Barclays Capital, said this argument was less important than what percentage of a portfolio should be allocated to commodities.

Some panelists at the conference pegged an allocation to commodities as high as 15%, but El-Asmar was more measured. "The proper allocation depends on the advisor, but the rough answer is 3% to 5%," he said.

RIAs Speak: Schwab Is Tops
Registered investment advisors are the most powerful asset-gathering force in the advisory industry. At least that's how they're described in a survey from Citigroup that examines the RIA space and what makes it tick. The survey says that the RIA segments at Schwab Institutional, Fidelity and TD Ameritrade garnered more net new assets during the past six quarters than Merrill Lynch, Smith Barney (a Citigroup subsidiary), Morgan Stanley and UBS combined.

The survey was chock-full of factoids about RIAs, but perhaps the juiciest tidbit in the report is this: Schwab was the custodian of choice by a landslide. If this were the Academy Awards, Schwab would walk off with the Oscar for best picture, director, actor, actress, screenplay-and maybe even costumes.
According to Citigroup, surveyed RIAs ranked Schwab first in each of the six categories rated. In the best service category, Schwab took top honors with 77% of the vote. Another 70% of RIAs said it has the best brand, while 68% said it has the best technology. When it comes to the best referral program, the best mutual fund offering and the lowest-cost service, Schwab finished first with 58%, 54% and 50% of the votes, respectively.

The Citigroup report found that the two leading considerations RIAs have when they choose a custodian are its service (29%) and technology (23%) capabilities. They also look at a custodian's costs (17%) and its mutual fund offerings (12%), take into account its brand (11%), and consider its ability to get them client referrals (8%).

As for custodian service levels, 82% of surveyed RIAs say they're serviced by a small team of four to five people, and 11% are serviced by a single individual. Just 7% are routed to a call center. Among RIAs with assets of more than $1 billion, 20% are serviced by a single representative and none are routed to a call center.

The Citigroup survey contacted more than 100 RIAs across the spectrum with an estimated 25,000 clients and $60 billion in total assets.

Pension Tension
Pension plans remain a factor in the nation's retirement income landscape, but they're taking a hit like most other investment vehicles and threaten to put a major hurt on the balance sheets of corporate America.

According to a recent report from the Center for Retirement Research, the value of equities in retirement plans plunged $3.8 trillion for the year ended October 9, 2008. Of that decline, half came from defined-contribution plans and the other half from defined-benefit plans. As of the end of 2007, defined-benefit plans represented 18% of all U.S. retirement assets.

The report, The Financial Crisis And Private Defined Benefit Plans, says that the number of underfunded plans has increased. In mid-November, after the report came out, about 300 leading companies and business groups asked Congress to suspend parts of the Pension Protection Act of 2006 designed to guarantee that the companies have enough funds to meet their pension requirements. The business lobby contends these mandates are straining their finances and might force them to cut jobs to conserve cash during the economic downturn.

The act requires defined-benefit plan sponsors to eliminate any unfunded liabilities over a seven-year period. The Center for Retirement Research found that based on the current depressed state of equities, plan sponsors next year will need to boost their pension plan contributions by $90 billion to meet their funding mandates.