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Will desperate hedge funds spark a year-end rally?

October 27, 2011: 10:40 AM ET

Hedge fund managers have a lot of catching up to do.

FORTUNE -- As odd as it may seem, an awful third quarter for the hedge fund industry, coupled with weak fund manager earnings in recent years, could kickstart a year-end rally.

Hedge funds posted their fourth-worst quarter in industry history in the recently finished third quarter, according to Hedge Fund Research Inc. That puts the industry down an average of 6% for the year. That's still ahead of the S&P's 10% drop through the first three-quarters of the year, but just barely when you include management fees. As a sign of just how bad most hedge funds are performing, HFR says 69% of hedge funds experienced net asset outflows last quarter - pretty dramatic considering the hedge fund industry overall has still enjoyed net asset inflows for the year. That implies a minority of funds are doing most of the gains (or least bad losses).

Another report by HFR, released earlier this week, notes that hedge fund manager compensation has never returned to the peak it hit in 2007. That's because a large part of hedge fund pay comes from taking a cut of profits clients make, usually 20% to 30% (another 2% to 3% of client assets are paid in management fees regardless of performance). Since hedge funds tend to see the biggest influx in new clients after they post excellent gains, it means many clients bought near performance highs. That means most clients aren't close to seeing profits in their accounts --perhaps just 19% or fewer hedge fund clients do, estimates Institutional Investor.

All this means hedge fund managers need to see a nice rally through year's end to both placate restless clients and to get their funds into the black and with it boost their pay. With the world's hedge funds controlling roughly $12 trillion, they have the heft to move the market. As long as Europe plays along with implementing its rescue, as it appears it is today, look for another Santa Claus rally to develop.

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