Hedge fund victims of their own success

Investment style profiles

THE HONEYMOON FOR hedge funds is over. Having wowed investors with returns of 11.2% in 2003, 4.14% in 2002, 9.36% in 2001, 13.48% in 2000 and 15.35% in 1999, according to the S&P Hedge Fund Index, the sector will struggle to post double-digit annual returns for 2004 after experiencing its most challenging quarter since 1998.

The S&P index, which represents a broad range of hedge fund strategies, was down 1.59% for the second quarter this year compared with a positive 1.92% in the first quarter. In the third quarter of 1998 the index fell by 2.63%.

In the past six years, hedge funds assets have ballooned. Estimates from Chicago-based research and data firm Hedge Fund Research (HFR) suggest that in 1998 total assets under management at hedge funds were $375 billion. By 2004 that had risen to about $865 billion.

Leverage gives hedge funds crucial extra fire power. So although assets under management are relatively modest compared with mutual funds' $7 trillion, their impact on financial markets is similar.

In the accompanying articles Euromoney examines how hedge funds have moved from being peripheral players to the key drivers of many financial markets and vital to capital raising in the primary equity and emerging debt markets. We also profile some recent strong performers.

But at the very moment when hedge funds appear to have transformed the way money is managed, their performance is slipping and investors are re-examining the myths that have grown up around the industry. These include the notion that hedge fund performance is independent of traditional cash markets and that different hedge fund strategies are always uncorrelated with each other.

Old concerns are resurfacing, such as hedge funds' reliance on leverage rather than smart investing to produce returns. Investors are also beginning to ask about survivor bias in performance figures – published figures tend to show returns for all hedge funds except the ones that have shut down. Style drift is also a growing concern as managers lose faith in their chosen strategy and seek to follow another in which they lack expertise. Poor internal risk management is another worry.

New questions are also coming to the fore. Have hedge funds simply become too big to generate the kinds of returns from market anomalies that they used to offer? Have fee structures tempted some managers to concentrate on asset gathering rather than performance?

Is the hedge fund bubble about to burst – as others have in recent years – or is it simply time for investors to rein in their over-inflated expectations of what hedge fund managers can deliver?

Recent poor performance is causing particular concern for investors who have been sold on the idea that hedge funds will deliver double-digit returns irrespective of the performance of stock and bond markets. Robert Brown, senior investment consultant at Watson Wyatt, says: "In general, people's view of 15% with 3% volatility is unrealistic. Alpha doesn't grow on trees." Barclay Group's president Sol Waksman concurs. "One of the greatest myths of investing is that there are people out there who believe that top hedge funds should make money in any environment," he says. "Nothing could be further from the truth."

Van Hedge Fund Advisors International has done its own research on the correlation between hedge funds and the market. "While there's a lot of talk about hedge funds not being correlated to the market, our research shows that all strategies, on average, have a correlation of around 0.7 to equity markets," says the firm's chairman, George Van. "This is meaningful but not academically rigorous."

Joe Nicholas, CEO at research and data firm HFR, says: "They all have a relationship with whatever their underlying market driver is."

Investors are relearning a hedge fund lesson. Rather than consistently producing high returns in a fashion uncorrelated to the markets, hedge funds tend to limit upside in a bull market but can protect assets in a down market. When the markets are moving sideways, hedge fund managers are just as paralyzed as traditional money managers.

Michael Maslinski, director of wealth management consultancy Maslinski & Co, says: "There's a lot of confusion about whether the role of hedge funds is to produce very high returns or to lower volatility to have better correlated investment portfolios [to liabilities]." He adds: "Our investors are in the pursuit of lower risk volatility and risk/return ratio."

Asset allocators are also questioning the scalability of the industry and whether the flow of assets into hedge funds has overshot the investment opportunities available and the limited number of highly talented managers able to take advantage of them. Many people, Maslinski says, are "scratching their heads at the moment about whether it's the right way to go or the next disaster area, as some people suggest".