Hedge Fund Hell

October 2, 2008 will be remembered as the day the 2 and 20 hedge fund compensation model officially broke. Many of the sectors and stocks that have a signficant concentration of hedge fund holders are down 10% to 25% today. Rails, Farm Equipment, Fertilizer, Steel, Coal, Infrastructure, and Mining are all down more than 10% as of 2pm ET. You will certainly be reading about major hedge funds closing or changing their incentive compensation model in the coming weeks because investors are not going to tolerate the vicious drawdowns that are clearly taking place.

I have attached below (in quotes) comments from my September 5 morning note because the factors that have weighed on the markets since then appear to be growing more formidable. Risk remains extremely high and tactical long opportunities require a tight stop-loss discipline: "Macro-related factors continue to provide formidable headwinds for global equities. Fears of a global economic recession, the perception that earnings estimates for the second half are too high, and the de-leveraging among institutional market participants suggest that the path of least resistance remains skewed to the downside. During Thursday’s session, rumors were rampant that multiple large hedge funds were encountering serious problems. These rumors circled during the November 2007 and January 2008 pullbacks and were completely exaggerated. But, these same rumors seem to have more credibility during the July/August 2008 decline because the sector rotations into and out of the energy and financial sectors have been extremely vicious and suggest serious stress among the holders of these assets (the Long Commodity/Short Financial trade has seen multiple trading days with moves of + and – 10% or more in just the last few weeks). Rest assured, Ospraie Capital is not the only major hedge fund blowing up, encountering serious stress, or seeing massive client redemptions. The first phase of the current credit crisis infected global investment and commercial banks; the second phase is clearly spreading to the hedge fund asset class and this appears more ominous because it occurs in the shadows. Nobody knows the extent of the damage and there is no mechanism like the various Fed lending facilities to gauge the quality of the assets and investment firm’s underlying health. Risk remains extremely high and discipline is critical. The odds of a hard test or substantial break of the July 15 lows is increasing with each session."