Why Do Hedge Funds Have So Much Dry Powder, and What Are They Doing to Keep It Safe?

Discussion in 'Professional Trading' started by ASusilovic, May 20, 2009.

  1. It is widely understood that investors pay hedge fund managers to invest money. A less appreciated, but increasingly common, service provided by hedge fund managers is not investing money. Is that latter service worth a two percent management fee? Consider a billion dollar equity long-short hedge fund with a two percent management fee that remained in cash for all of 2008. The fund would have charged investors $20 million for sitting in cash. Seems unfair: why should investors pay the manager $20 million when they could leave the same money in the bank more or less for free? The answer is that a bank is not really a viable alternative: most institutional investors in hedge funds have internal allocation policies that require a certain percentage of assets to be invested in hedge funds. Thus, the appropriate comparison is not between a hedge fund and a bank, but rather between a hedge fund manager who stayed in cash (or largely in cash) and another hedge fund manager who was fully invested. If that same billion dollar equity long-short hedge fund were fully invested in the S&P 500 during the same period, it would have lost about 38 percent of its investors’ assets. Even if half of those losses were offset by a short book, the fund still would have lost $190 million. Most investors would be willing to pay $20 million to avoid a $190 million loss. As any seasoned investor will tell you, the first rule of investing is not to lose money. During 2008 and early 2009, the amount of cash – known in the trenches as “dry powder” – held by the more judiciously managed hedge funds has risen dramatically; the cash has come from asset sales and new investments. The dramatic increase in cash held (as opposed to re-deployed) has been driven largely by three factors: (1) fear of getting back into the market too early; (2) desire to avoid selling assets at depressed prices to satisfy redemption requests; and (3) concern about being prepared to seize new investment opportunities at a time when the opportunity set becomes more compelling but leverage remains unavailable. We explain why hedge funds are holding so much dry powder, and what the more prudent managers are doing to keep it safe. We weigh the pros and cons of money market funds and Treasurys, and highlight what is probably the safest strategy for cash management.

  2. Any decent hedge fund manager makes sure that the cash balance is getting the highest risk free % that is possible. Some strategies require cash available on the sidelines to take advantage of great opportunities.
  3. Couldn't they invest into short term T Bills in the first place since holding them to maturity means they are essentially like cash? I don't think it makes sense to be charged a fee if the fund is simply hoarding cash.