Hedge Funds to Prosper By Hedging Out the Toxic Waste

Things aren't quite as dire in the hedge-fund industry as money managers originally believed. At least that's the latest message from financial research departments, which are concluding that although the hedge fund industry has shrunk some $400 million in the past year, it still represents a colossal $1 trillion plus pool of investment capital.

Largely, that's because the managers sat on cash and limited redemptions last year just as things were getting ugly.

Citigroup estimates that hedge fund managers are currently hoarding some $294 billion. That's not being invested as quickly as you might think, either: only around a third of that, or $82 billion, will be deployed over the next six months.

Those numbers beg a big question. With equity valuations so cheap, and stocks finally beginning to rebound, what purpose does it serve investors to invest with the funds? After management and performance fees, you're just giving away 20 percent for the obvious (an upturn) -- and for storing a third of your own cash. That may be why most funds are slashing management fees to 0.8 percent (vs. the traditional two percent) and in some cases, abolishing them altogether.

Bad Assets, Great Returns
One way in which funds may be able to overcome this problem is by getting access to the kind of low-risk, high-return deals that you and I just aren't eligible to invest in. That's the traditional way institutions lure clients, after all -- with access to specialized products such as major IPOs.

The latest Obama administration plan to offer hedge funds an opportunity to partake in mopping up some of the toxic assets on the big banks' balance sheets -- which the government has already, in effect, guaranteed -- is a compelling reason to invest with the hedgehogs.

BusinessWeek notes, succinctly: "The plan uses cheap government financing to offer would-be buyers of toxic assets the potential for juicy double-digit returns. Taxpayers are left to shoulder most of the risk."

The average fund needs to make back about 23 percent of its capital before it can start taking its performance fees from existing investors. The biggest threat that hedge funds pose to the economy right now is that as they attempt to control costs, they are laying off large numbers of junior employees: estimates range up to 20,000 potential jobs losses in the industry this year. With the economy finally starting to show signs of shrinkage in unemployment, a round of giant layoffs this year could slow the recovery.

Double-digit returns on these assets would help shore some of that leakage up. The plan would also motivate hedge funds to deploy some of that third-of-a-trillion dollar slushfund back into the financial system, giving a much needed boost to liquidity right now.

If politicians can show some rare ideological restraint and hold their breath here, the consequences could help serve as the beginning of the end -- or, at the very least, usher in the end of the beginning.