November 2008

HEDGE FUNDS: It's been tough

Hedge funds of funds are seen as a lower risk investment option than single strategies. Lynn Strongin Dodds looks at how recent market conditions have treated them Hedge funds have always had a controversial tinge about them but in the past few months, they have come under heavy attack for the role they have played in the current financial crisis. They may argue, though, that while they were active participants in the leverage game, they were not alone and are now, along with many others, paying the price. As with all assets today, fund of hedge fund  investors are well advised to carefully examine the underlying strategies.

There is no doubt that the hedge fund industry is suffering. September was the worst month in ten years, with performance dropping by 4.68% – the fourth consecutive month of negative returns, according to data provided by Hedge Fund Research (HFR). Overall, returns for the HFRI Hedge Fund Weighted Composite Index in the first nine months of 2008 slumped 9.4%. August 1998, though, still holds the record with an 8.7% drop due to the market volatility triggered by the collapse of hedge fund manager Long-Term Capital Management.

Slow recovery
HFR figures also reveal that funds of hedge funds, which typically have lower volatility than their single-strategy counterparts, were also not unscathed. Returns for the Fund of Hedge Funds Composite Index fell 4.95% for September and over 11% for the first nine months of the year.

Bill Crerend, chief executive of hedge fund of funds at EACM Advisors, an investment advisory firm that is part of BNY Mellon Asset Management, says: “There has been pain in the last 15 months, with the last quarter being the toughest. I do not think things will change overnight. This has been a liquidity and credit-driven event. The first priority is to get the system unclogged and get liquidity moving for short-term lending purposes. In the longer term – over the next three years –  there should be great opportunities that hedge funds can exploit.”

One of the issues, according to Randal Goldsmith, director of fund research at S&P Fund Services, is that fund of hedge fund investors viewed hedge funds as an asset class that generated absolute returns regardless of market conditions. “This has not been the case. In the TMT [technology, media, telecoms] collapse in 2000-2002, hedge funds continued to make money as they were able to identify stocks that were overvalued and short them while buying undervalued small and medium sized ‘old economy’ stocks, as well as those of emerging markets. The difference today is that market conditions are much worse because liquidity has been withdrawn.”

The collapse of Lehman Brothers sent shock waves through the industry and prompted a temporary ban on short selling financial stocks. Donald Pepper, head of alternative investments at New Star Asset Management, says: “Short selling did have an impact on some strategies but what was more profound was the fierce sector rotation in a short period of time. That led to wild price swings and negative performance as correlations rise when there are big market trends. However, several high quality managers were caught out.”

Winners and losers
In fact, according to HFR, managers investing in macro-economic variables were the only ones to have made money. Global macro funds lost 1% in September but were up 2.5% in the year. Equities managers, who bet equal amounts of money on rising and falling prices, also fared relatively well, losing only 0.3% in September, leaving them up 0.1% this year.

Long/short funds investing in equities, however, slid 9.6% for the month and 14.5% for the year while strategies focused on energy and basic materials took a beating, registering declines of 13.2% for September and 20.8%.  However, worst hit were convertible bond arbitrage funds, which seek to exploit inefficiencies in the pricing of a company’s stock and its bonds that can be converted into stocks. Returns fell 13.7% in September, which left them with a negative 21.9%, according to HFR data. 

Some convertible bond arbitrage funds were hurt by the short-selling ban. They, as a group, hold a large portion of the world's convertible bonds, but were forced to sell them in September to meet upcoming redemptions from their investors, sending the bonds’ prices down. Typically, hedge funds speculate convertible bond prices will rise, and the associated shares will fall.

Shorting and the lack of cheap funding also hurt statistical arbitrage funds, which employ mathematical models to identify tiny price discrepancies and then use significant amounts of borrowed money to bet that such price discrepancies will correct. Eric Bissonnier, partner and chief investment officer Europe and Asia at fund of hedge fund firm EIM, says: “Statistical arbitrage relies on a very wide universe of 3,000 to 5,000 stocks but the model is precise and if 800 or 900 stocks are cut out due to the ban on short selling, then it makes life difficult.”

Going forward
Looking ahead, there are fears that the end of the third quarter might have seen investors pull record amounts of cash. It is too early to predict the level of redemptions. The industry has already seen high-profile firms such as Peloton Capital Partners, Carlyle Capital Corp and Dillon Read Capital Management close their doors, and more are likely to follow. Fund of hedge fund managers, though, do not necessarily see the shakeout as a bad thing for the $2 trillion industry, which boasts close to 10,000 funds.

Sophia Brickell, specialist in the fund of hedge funds division at asset manager GAM, says: “According to HFR data, in the first half of 2008, a total of 350 hedge funds were liquidated, an increase of 15% over the first half of 2007.  At the current rate, this implies that approximately 700 funds could close for the year, which would be an increase of 24% over 2007’s total, although after the turmoil of the third quarter and September in particular, this figure could rise even further. Although this has been a particularly painful period for many, we believe that it will be a healthy process for the industry. There have been a lot of less able managers who have been able to raise large amounts of money in recent years and this environment will separate out those from the experienced managers.”

Christopher Khaw, of private bank Lombard Odier, agrees. “At the moment we are in this vicious cycle of redemptions and underperformance and no one wants to take a risk. At the end, though, there will be fewer funds. One of the main problems is that we have had three to four years of strong performance and this is the first time that many of them have been tested. When the markets stabilise, the managers that will survive will be those that have come through the worst financial crisis and they will stand to benefit.”

Fund of hedge fund managers also believe investors will continue to gain from spreading their risk across a broad universe of strategies, albeit at the moment the viable ones have shrunk. Brickell, at GAM, says:ââ?¬Ë?“Aside from the diversification advantage, fund of hedge funds also enable investors to access excellent, but less accessible managers, often under more favourable terms. We run a rigorous investment process and out of the 1,000 to 1,500 hedge funds that we see a year, we tend to invest in less than 5%.

“We also tend not to invest in lock-ups as GAM Multi Manager’s philosophy is to maintain liquidity and flexibility. For example, at the end of January 2007, we reduced significantly our allocation to equity hedge and increased our exposure to discretionary and systematic macro strategies in order to protect portfolio returns in the increasingly volatile market environment.”

Greater understanding
Steve Kelly, senior analyst at Maitland, a global fund of hedge funds firm, says: “Institutional investors have to look under the hood and have started asking their fund of hedge fund manager detailed questions. They should be much more proactive and make their managers go line by line through every underlying investment so they better understand how the strategy works.”

Pepper, of New Star, also believes that investors will have to be more modest in their expectations. The days of the double-digit returns may be over but despite their weak showing in September, hedge funds still outperformed the S&P 500, which posted its lowest close in five years at 32% for the year to date. “In 2001 and 2002, investors were happy with returns of between 4% to 6%, but in the bull market they were willing to accept a more ambitious risk-return profile. Going forward, I think the goal will be not to capture as much upside but to protect the downside. As a result, return targets are likely to be in the 8% to 15% range rather than 20% plus.” ©2008 Funds Europe

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