Outlook 2008 (The watch list): Hedge funds

The pain has just begun for hedge funds.

Late 2007 saw a number of sub-prime-mortgage-related blow-ups in the United States — notably two hedge funds run by investment bank Bear Stearns. But according to research firm Morningstar, the 7,500 hedge funds it tracks returned 3.3% in October after a 1.8% loss in August. So is the worst is over? No, says Peter Clarke, CEO of Man Group in the United Kingdom, who predicts one in 10 funds will close in the next six to 12 months due to poor credit markets — twice the average rate.

Nadia Van Dalen, hedge fund analyst at Morningstar, won’t guess about whether there will be more fund closures than usual next year, but she does say funds will have a harder time generating returns if the credit crunch continues. Many funds borrow to cover their positions. With banks reluctant to lend, capital may become more expensive, and hedgies may be forced to sell leveraged positions they’re no longer able to finance. Highly leveraged funds also tend to get hit the worst during market shocks such as the one in August, so funds might not take on as much risk when making bets in the future. Adding to the difficulties is that funds bet on corporate events such as buyouts and share buybacks, but companies will be less likely to conduct such activities with credit markets tight, Van Dalen says.

Howard Altman, an adviser to hedge funds with accounting firm Rothstein Kass in New York, is confident managers will still find ways to profit — after all, many funds already benefited by playing the other side of the sub-prime market. “Managers can make quick decisions, go in and out of markets, and ultimately take advantage of them,” he says.