Many are shutting down. The survivors will likely obtain fewer possessions and lower fees. Funds of hedge funds are suffering, too

By Matthew Goldstein

Watch full size video:

The arrest of Bernard Madoff, the financier who allegedly ran a $50 billion Ponzi scheme, could indication the close of the disappear national debt industry as investors comprehend it.

Hedge funds have been in a downward spiral for months as the markets have cratered and wealthy investors have pulled more of their money out. Supposedly not to exist stormed portfolios, such during the time that those at Citadel Investment Group, have lost half their value in the past year. Even so, Wall Street stayed optimistic that investors would rescind their pending performance requests if the markets stabilized, thereby buoying the industry’s fortunes.

But the Madoff mess, in which gross losses could exceed $20 billion, has dashed any hope for hedge funds. As the list of investment managers, banks, charities, and celebrities allegedly fleeced by the former presiding officer of the Nasdaq stock market has grown, investor confidence has sunk to an all-time low. It could take years for managers to regain that trust. And the industry that emerges from the other side of this crisis will likely be estranged humbler, smaller, and cheaper than the one that began the year with nearly $2 trillion in assets. "The Madoff thing couldn’t come at a worse time," says Sol Waksman, founder of industry tracking service Barclay Hedge.

Until now, the exit toll of funds has been minimal as managers clung desperately to the notion that the chaos would subside. But with little accident of that happening soon, hundreds of hedge funds suffering double-digit losses have no choice but to shut their doors. The ensuing wave of liquidations would be a sober start to the New Year, further depressing prices of stocks, bonds, and commodities. It could mirror the tumult last fall when stocks dropped 30% in six weeks, driven largely by a sell-off in hedge funds. Hedge public funds assets, already down 25% since the move of 2008, could send down to less than $1 trillion in a year.

So-called funds of proceed stealthily funds, which buy stakes in multiple hedge funds, will be among the hardest hit. Besides offering a diversified investing. that supposedly reduced the risk of a blowup in any single portfolio, fund-of-funds managers assured clients they had conducted deep inquiry on the underlying hedge funds. But many funds of funds, including ones at Man Group (EMG.L) and Banco Santander (STD), plowed money into Madoff’s rooted. One of the biggest: Fairfield Greenwich Group, what one. invested nearly half of its $14.4 billion with Madoff. The mistakes have dealt a black eye to common of the arrange’s indispensable sales pitches.

In the unlikely event investors bestow funds of funds a move on this disaster, the banks that lend wealth to these portfolios may not. Even though banks started cutting back credit lines to funds of funds earlier this year, the Madoff scandal unfolded so quickly that many lenders have been blindsided and could be exposed to hefty losses as a result. For example, France’s BNP Paribas (BNPP.PA), which supposing credit to funds of funds, says it could take a $470 million hit. Lenders, check licking their wounds, may exist reluctant to lend to funds of funds for quite a season. "Financial institutions that have felt penalty don’t quickly forget," says Charles Geisst, a finance professor at Manhattan College.

All that is raising serious doubts with respect to the viability of funds of funds—and the long-term prospects for hedge funds in general. After all, funds of funds narration according to roughly 43% of the industry’s assets. "There are going to be more tough questions," says Chris Addy, chief charged with execution of Castle Hall Alternatives, a hedge fund just title diligence firm.

The ramifications will be felt by reason of years to come. Without the huge source of ready money, the pair from funds of funds and brim credit lines, hedge fund returns will pocket on a level after the markets rebound. For one, it’s disagreeable to produce double-digit returns free from borrowing money to leverage assets. And during the time that expectations come down, fees most certainly will follow, since investors won’t subsist willing to cough up 20% of profits. In the end, the industry may revert to its style in the 1980s, when obstruct funds tried merely to outpace the market modestly. "Hedge funds became a disguised way to ramp up in the same manner with abundant short-term profit in the same proportion that possible," says Geisst. "That’s the exact opposite of what a orally transmitted obstruct fund was supposed to be."