Bloomberg – Hedge-fund assets may fall to about $1 trillion by the middle of next year, a decline of almost 50 percent from their peak in June, because of market losses and client withdrawals, Citigroup Inc. said in a report.

Managers are likely to see investors, led by funds of funds, pull 20 percent of their money, Tobias Levkovich, an analyst at the New York-based bank, wrote yesterday. Funds of funds are middlemen who select hedge funds for their clients.

“The so-called `Swiss hot money’ wants out and funds are responding,” Levkovich wrote, referring to Swiss investors who have a shorter investing period than pension funds. “Citi’s credit analysts estimate that hedge funds have raised cash to roughly 40% of assets already in anticipation of known redemptions and possibly unanticipated demands from investors.”

Hedge funds lost an average of 16 percent this year through October, according to data compiled by Hedge Fund Research Inc., as stock and commodity markets tumbled and lending tightened. The industry has lost money in only one year — a 1.45 percent decline in 2002 — since the Chicago-based firm began tracking returns in 1990.

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AllAboutAlpha.com – The Bank for International Settlements in Basel, Switzerland was probably abuzz last week watching history unfold before its eyes.  After all, one of the lynchpins of the organization’s Basel II Accord was the requirement for banks to mark-to-market all assets – including less liquid ones.  And it appears that doing so in a leveraged environment has put several banks into a death spiral in recent weeks (see featured post below).

But the BIS is also keeping an eye on hedge fund leverage.  The organization just released a working paper called “Estimating Hedge Fund Leverage” that proposes a new method of calculating the level of leverage used by hedge funds and, it is hoped, a way to measure any resulting systemic risks to the financial system.  Regular readers may remember that this topic was also covered by the Fed’s Tobias Adrian last year.

As the authors of this report point out, leverage comes in two basic forms: funding leverage – where you literally borrow money to goose returns (or losses) and instrument leverage - where the securities themselves have leverage baked in (such as a futures contract, option or swap).  But at the end of the day, if a fund rises twice as much as the market on “up” days and falls twice as much on “down” days, then the source of leverage is less relevant.  In fact, divining leverage based on historical returns will also capture the leverage implicit in the balance sheets or business models of individual securities.

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