Not long ago, clients of Hawthorne, the multifamily office unit of PNC Financial Services Group Inc., were demanding more hedge fund choices.
That has all changed since Dec. 11, when the financier Bernard Madoff was charged with perpetrating a gigantic Ponzi scheme. Now Hawthorne clients do not want to hear about hedge funds, said Thom Melcher, the business' chief investment officer.
"The first question has been, 'Are you bringing me something that is a hedge fund and that has a lockup?' " Mr. Melcher said. "If the answer is yes, we can't even get to explaining the investment thesis and the potential return."
The specter of fraud is likely to stalk the hedge fund industry in 2009, experts agree. But that is just one concern for the industry, which is also facing investors exasperated by hedge funds' poor performance and their long "lockup" periods, in which investments cannot be withdrawn.
Tough new hedge fund oversight is also expected. A Senate bill introduced last week would bring the virtually unregulated investment pools under Securities and Exchange Commission jurisdiction. Hedge fund investors are eager to have more information on matters such as how their money is being invested and how dependent their returns are on leverage, said Lee Giovannetti, the chief executive of Consulting Services Group LLC, a Memphis firm that advises institutional and individual investors.
"There is very little confidence across the board with the current regulation system," he said. "Our clients and most institutional investors we're talking to would welcome more transparency."
Concerns about hedge funds' shortcomings are rippling through the all-important institutional investor community, which had relied on them to mitigate investment risk.
"Institutional investors, whether endowments, foundations, or retirement plans, are really kind of at a crossroads now," Mr. Giovannetti said.
Endowments and foundations are particularly anxious about the lack of access to money they have invested in hedge funds. Hedge funds routinely require investors to keep their money with the fund for a lengthy period, and in recent months many have taken steps to delay redemptions further.
That is "very, very concerning" for endowments and foundations because they need cash to meet commitments they have made to other alternative investment managers, Mr. Giovannetti said.
Pension managers' worries, meanwhile, center on performance and disclosure issues, he said. They are particularly concerned with the problems dogging one of their favorite investment vehicles — funds that invest in multiple hedge funds. Many nonpension investors have been winding down their positions in the funds of funds, which has forced the vehicles' managers, in turn, to make redemptions in the only places they are available: the best-performing hedge funds.
Pension investors are concerned "that they have been thrown in there with investors that do not have the same characteristics and objectives," Mr. Giovannetti said.
Many observers predict large investor redemptions this year and continued consolidation on a large scale for the hedge fund industry. When investors are finished skimming out the truly capable hedge fund managers from the duds, the remaining funds will manage perhaps $500 billion, said John Osbon, a Wall Street veteran and the founder of Osbon Capital Management in Boston. Estimates of the hedge fund industry at its peak early last year exceeded $2 trillion. "The industry must shrink to improve," Mr. Osbon said.
It certainly shrank last year. With redemptions soaring — in October and November alone investors pulled out more than $40 billion — funds appeared to be folding in droves, according to Morningstar. In 2008, 1,158 single-manager funds and 490 funds of funds were removed from the company's database because they liquidated or stopped reporting returns. That total was up 150% from 2007, according to Morningstar.
Underlying the contraction was dismal performance of the global hedge fund industry. Its investment losses last year were $185 billion, while fund liquidations and investor redemptions eliminated another $198 billion, according to Eurekahedge, a research firm based in Singapore.
Investment losses accounted for $185 billion of the decline, while net asset outflows from fund liquidations and investor redemptions made up $198 billion, according to the data provider. Hedge funds' losses last year averaged 18%, according to Hedge Fund Research Inc. of Chicago. The fact that most hedge funds could not capitalize on their short-selling ability to profit from the plunging markets has put the lie to their supposed superiority, Mr. Osbon said.
"How, in a market that's down 40% — and you can short — can you lose 18%?" he asked.
Poor returns ensured that hedge fund executives would have little chance to collect their all-important performance fees anytime soon, and that has been a big factor in the fund closures, according to industry observers.
There is at least some evidence that hedge fund investors are shopping around for alternatives. Over the past few months, a unit of Invesco Ltd. in Atlanta has pulled more than $500 million of new assets into its absolute return strategies portfolio, said Scott Wolle, head of Invesco Multiple Asset Strategies. The hedge fund alternative has relatively low fees and no lockup period, he said.
"We're seeing a lot of interest from big institutional investors right now," Mr. Wolle said. "They are massively frustrated by the inability of hedge funds to do what they were designed to do."
Yet Mr. Giovannetti is not persuaded that huge redemptions are in the cards in 2009. In fact, most institutional investors he has spoken with are not shying away from hedge funds, he said. Pensions look at hedge funds' current situation as an anomaly, and have little faith in the alternative of buying and holding equities, he said. Meanwhile, endowments and foundations are still preoccupied with liquidity and are "not worrying about allocation yet," he said.