The $2 trillion hedge fund industry has experienced contrasting fortunes due to the financial crisis and the regulatory crackdown on short-selling, a practice that has for years been one of the key tools in the industry’s armoury, according to research undertaken by New York-based Credit Suisse/Tremont.

Credit Suisse/Tremont hedge fund index group consulted with hedge fund managers in order to assess how the current extraordinary market situation could affect fund performance and analyse the steps that fund managers are taking to navigate these difficult market conditions.

Meanwhile, Credit Suisse/Tremont estimates that its index for overall hedge fund performance is likely to show a drop of 6 per cent in September, compared to a loss of almost 9 per cent for the S&P 500 index of US stocks.

Starting with the bankruptcy of Lehman Brothers in September, fund managers queried by Credit Suisse/Tremont said that prime broker and counterparty exposure to Lehman Brothers appears to be limited. The failure of Lehman Brothers had been anticipated and many managers were pro-active in managing their exposure.

The research also note that many large funds work with several prime brokers, thereby limiting their dependence on and exposure to any single prime service provider.

Short sale bans are affecting funds across strategies to varying degrees. Some sectors, such as convertible arbitrage, may be significantly affected as fund managers are unable to hedge the equity portion of their convertible bonds.

Funds without specific exposure to the financial sector have reported a limited impact on performance, since the ban was limited to the shares of certain financial institutions. Certain funds managers do, however, seem to be changing their portfolio behaviour in order to avoid disclosing their positions, and this could have an impact on performance.

Those funds that have performed relatively well to date are typically holding net short positions on broad equity indices or on overvalued financial and consumer related equities.

Despite fluctuations in the markets, managers with net short positions in these sectors have generally been rewarded as their positions yielded positive results. Managers holding short positions in the financial sector before the shorting ban, generally maintain those positions.

Managers surveyed describe an overall increase in cash levels being held by funds across the board. In less liquid sectors, this stockpiling of cash may be in anticipation of redemption requests; however, the higher than average cash exposure can also be attributed in part to de-leveraging. Many funds are also holding cash in an effort to be prepared to seize opportunities as they come.

In the short term, some managers predict that stricter lending rules could raise borrowing costs and increased government regulation could affect investment decisions. Managers in general are being proactive in reducing exposure and risk and the actions that fund managers are currently taking - namely, increasing cash balances, de-leveraging and capitalizing on short positions - are strengthening their balance sheets as they wait for opportunities to arise.