The Year Hedge Funds Got Hit

Hedge funds, the highflying darlings of the investment industry, have fallen to earth. These funds meant for sophisticated, rich investors just endured their worst year ever.

The industry was down 18.5 percent as of November after an unprecedented six-month streak of losses. The amount of money the hedge funds had to invest, which peaked at almost $2 trillion last June, shrank by almost one-fifth by October, according to Chicago-based Hedge Fund Research. Some fund managers say the industry's capital could shrink by as much as 75 percent.

Tens of billions of dollars are being pulled out of these secretive funds by nervous investors who seek to put their money in safer alternatives or need cash to meet other investment obligations.

The wild swings in the stock market last year were due in part to hedge funds selling assets to meet redemption requests and to reduce leverage levels, analysts said.

The past 12 months have been "an indescribably horrific year and everything's been down," said Robert A. Dennis, investment director of Massachusetts Public Employee Retirement Administration Commission, which oversees municipal pension funds, a number of which have invested in hedge funds. "This year is to be written off as a horror movie to be seen once and never again."

Once predators on the margins of the market, hedge funds have grown into integral participants. Now they are under enormous stress. Congressional hearings have highlighted their potential to put the global financial system at risk through excessive use of debt to finance investments and through extensive links with banks and other large financial institutions. More and more pension funds and college endowments have been investing in hedge funds, and pressure is mounting for regulation of the funds.

"We've been living on borrowed time in that the industry has grown far more rapidly than we've been able to support with the existing legal, regulatory and investment infrastructure," said Andrew W. Lo, director of the Massachusetts Institute of Technology's Laboratory for Financial Engineering.

Though hedge funds are suffering, they have lost only about half as much value as stocks, which declined 38 percent last year, as measured by the Standard & Poor's 500-stock index.

Most institutional investors seek a diverse portfolio of multiple hedge funds, said David Shukis, director of hedge fund research and consulting for Cambridge Associates, which advises college endowments and other institutional investors. "That combined with very good performance relative to equities going into this has led most investors to think that it's still an attractive investment to have in their portfolio."

But that is still billions of dollars in losses for investors, which include typically staid public pension funds. In Pennsylvania, the state pension fund declined 14.4 percent in the first nine months of last year, to $29.2 billion. Just under one-fifth of its assets were in sophisticated investment strategies that included hedge funds. Those strategies were down, on average, 31.5 percent in the same period.

Ordinarily, market turmoil and economic volatility are good conditions for hedge-fund masters like Paul Tudor Jones, who foresaw and profited from the 1987 market crash. But now even Jones, hailed as a "financial alchemist" and "market wizard," is finding he is all too human.

His $10 billion flagship fund, Tudor BVI, is on track to have its first down year in 22. So many investors want to yank their money out that the fund has for the first time temporarily barred them from doing so. In a Nov. 28 letter, Jones asked them to "pause" while he deeply rethinks his strategy.