Hedge funds, which experienced sharp drops in assets during the credit crisis, now hold an all-time high of more than $2 trillion in capital, according to a new survey by Hedge Fund Research Inc., which analyzed their first-quarter numbers. The figure is a 50% improvement from crisis-driven lows reached in the first quarter of 2009. Investors allocated $32 billion in net new capital in the first quarter, the largest quarterly net inflow since the third quarter of 2007, the firm said.
The financial crisis and recession took a heavy toll on the sector: The investment environment was so severe in 2008 that nearly 700 hedge funds closed in the first three quarters.
The question now is whether hedge funds' assets are about to move down again. While some make money through investments in currencies and options, others rely on bets which cover stock market increases and the rise in commodities prices. It's almost certainly no accident that fund sizes have grown during the last two years, a period in which the Dow Jones Industrial Average moved up nearly 60% and the prices of some commodities doubled.
The investment advantage of hedge funds is that they use their borrowing capacity as leverage to increase their ability to make investments, but this advantage is can also become their Achilles' heel. If their investments falter, their ability to pay back what they have borrowed is often limited. The funds' high level of leverage also threatens banks, because they are usually the sources of the borrowed capital.
Excessive leverage was, in the minds of many analysts, one of the key triggers of the financial crisis. Bankers would argue that their balance sheets are stronger than they were in 2008, when they held tens of billions of dollars in mortgage-backed paper. That improvement will not keep bank earnings from suffering if bets by some hedge funds do not play out and financial firms are unable to recover the large amounts of money they loaned to them.