February 22 2008: 1:21 PM EST
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Dark days for hedge fund king

Clifford Asness's model-based strategies made him a darling among investors. Now his firm faces steep losses and the threat of an employee exodus.

By Roddy Boyd, writer

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NEW YORK (Fortune) -- Welcome to superstar hedge fund manager Cliff Asness' winter of discontent.

Asness' AQR Capital Management has notified investors that its Absolute Return Fund, long one of Wall Street's most stellar performing quantitative hedge funds, lost 15 percent of its value through mid-February. The slide follows an 11.9 percent drop through the end of November.

Bloomberg reported Friday that AQR flagship hedge fund now manages $2.9 billion, down from $4 billion.

The steep losses have dealt a major blow to Asness, a University of Chicago-trained mathematician whose investing prowess catapulted him into the ranks of the super-rich, and his firm. Founded a decade ago with fellow Goldman Sachs alumni, AQR now faces the daunting prospect of employee defections, falling management fees, and credit problems.

AQR, based in Greenwich, Conn., has long been one of the most prominent hedge funds to use complex mathematical formulas to spot - and profit from - temporary inefficiencies in stock prices. Before launching AQR, Asness and his co-founders developed the computer models that helped Goldman Sachs' Global Alpha fund return 140 percent in 1996, its first year, and regularly book handsome double-digit returns before finally collapsing last year.

The strategy that Asness used is known as quantitative trading, or "black box trading" given its reliance on computers to execute trades. Over the years, AQR's founders built a money management franchise with $36 billion in assets, $11 billion of which was invested in hedge funds.

For AQR's management, the payoff from quantitative investing was exceptional. Institutional Investor magazine regularly named Asness one of the highest-paid hedge fund managers. In 2002 and 2003, he reportedly pocketed $37 million and $50 million, respectively.

Those days are over - at least for now.

Quantitative funds have been devastated by the market volatility that began last summer. At one point in July, the AQR Absolute Return fund booked a 13 percent loss. While it recouped about half of that loss later in the month, the fund's once-resilient mathematical models were no match in the face of a global credit crunch, the severity of which few predicted.

Worse for AQR, the firm could now see its star employees head for the exits. That's because of a peculiarity of hedge fund management called the "high-water mark," in which a fund manager must recoup the amount of prior losses before earning the lucrative 20 percent and higher performance fees. AQR's rank-and-file traders and analysts now have little incentive to stick around - unless, of course, the fund's owners guarantee them compensation from a cut of their fees.

Yet another potential blow: Banks and brokerages that provide hedge funds with the leverage they need via loans and lines of credit traditionally could begin to curtail or charge more for these borrowings when double-digit losses are posted.

A fund spokesman declined comment. To be sure, AQR's non-hedge assets, which are the bulk of the firm's assets, are ahead of their primary return targets for the year.

Even so, this is likely to be a winter Asness never forgets. To top of page