HEDGE FUNDS MUST strive to keep up with returns offered by the cash equity markets this year if they are to continue to attract funds at the same rate as in 2003.
Moving into hedge funds in 2001 and 2002 was a good way for smart investors to preserve their money in a bear market. In 2003, though, even as the industry enjoyed record inflows estimated at $60 billion by Tremont's Tass Research, hedge fund indices underperformed the S&P500.
To compete this year if cash equity markets keep rising, hedge funds must focus on product innovation and the development of new strategies.
Among those now emerging are credit long/short, a quasi-private-equity approach and what are called new alternatives, such as weather derivatives and catastrophe bonds. Another tactic for hedge fund managers may be to seek flows of money coming out of bond allocations.
Most hedge fund managers expect the equity markets to continue to thrive in 2004. It follows that the hedge fund strategies with the best prospects tend to be those that did well in 2003, for example, event-driven strategies and global macro.
Hedge fund managers, fund of funds managers and advisers are more cautious on emerging markets, distressed debt and high-yield strategies this year.
The record inflows into hedge funds in 2003 compare with much more modest inflows of $16.3 billion for the full year 2002 when the bear market in straight equities was still raging. This raises the question whether the growth in hedge fund investing is now so well established as to be immune to cycles in conventional market returns.
According to the Goldman Sachs/Russell alternative investment survey, the number of organizations – out of the 325 that responded – that invest in hedge funds increased by 40% globally in the two years to summer 2003. There is currently about $725 billion invested across about 6,380 hedge funds globally, according to figures from hedge fund advisory Hennessee Group (see chart). Philippe Bonnefoy, independent adviser to Commerzbank Securities' Alternative Investment Strategies, says: "I predict that there will be $1 trillion in hedge funds by 2006."
But many in the industry feel that a sustained rally in the equity markets could yet stem the inflow. George Van, chairman of Van Hedge Fund Advisors International in the US, says: "A little [movement of funds from hedge funds to equities] has happened already because hedge funds are struggling to keep up with equity markets." Chris Woods, head of the hedge fund division at State Street Global Advisors, says: "If hedge funds only deliver single-digit returns this year people won't be interested, unless the equity markets drop."
Others expect a speedy return to the old styles of fund management as cash equity continues to revive. Charles Gradante, CIO at Hennessee Group, says: "The [state of the cash equity] market in 2003 resurrected a euphoria about long-only money management. I think the rate of money flowing into hedge funds will slow down."
One fund of funds manager even predicts net outflows from hedge funds if the stock market continues to rise rapidly. Craig Reeves, managing director at fund of hedge funds Platinum, says: "Investors have very short memories from a hedge fund buying view. They wanted risk-adjusted returns but mandates change quickly from fear and protection to greed and gluttony."
Other industry players suggest that while cash might flow into equities, hedge fund managers might still benefit from reallocations from other asset classes.
Hennessee's Gradante says: "Institutions are getting out of the bond market in droves. Some of this money will go into hedge funds because they're reluctant to put more into equities." He adds: "People are asking us: 'can we get those returns [such as those expected from bonds] from convertible arbitrage and other arbitrage strategies?' The answer is 'yes'."
Sticking with diversification
To ensure continued investment, hedge funds must remain diversification plays and show little to no correlation with equity markets. Bonnefoy says: "The question is, how to create value without directional exposure. This is our key job."
The credit long/short strategy has gathered momentum over the past year. This is a result of the increased liquidity of the credit derivatives market over the past 18 months. Sanjay Tikku, head of investment strategies for Europe and Asia at fund of hedge funds Tremont Capital Management, says this strategy is one of the most interesting new areas. "Two years ago there were only a couple of [credit] long/short experts. Then, last year alone at least 10 new funds were launched."
There is also some development in the long/short equity world. Strategies are becoming more specialized. For example, some managers focus on a specific industry sector or geography and some are developing a variation on the style. Lindsay Jones, head of business development at Orn Capital, says: "For example, there's a quasi-private-equity approach where you take a fairly significant stake – say 10% – in a publicly listed company and hold it for a period of time.Very few funds are doing this at the moment. [But,] the idea is gathering momentum."
New alternatives, such as weather derivatives and catastrophe bonds are also slowly gathering momentum as liquidity picks up and hedge funds are playing their part. Jones explains: "Instead of passing off their risk to reinsurance companies, insurance companies are starting to [securitize their insurance policies and] issue catastrophe bonds where they pay a coupon to investors but if there's trouble the investor pays up." One hedge fund that invests in both instruments is Systeia Capital Management. Jean-Louis Juchault, president and CEO of Systeia, says: "We are arbitraging the risk, so, the probability of the event occurring."
Juchault explains: "For example, an earthquake in San Francisco could happen once a century and, say, the insurance company is willing to pay over 1% over the probability of the event occurring. So, what we're doing here is benefiting from the fact that they're ready to pay more than the mathematical price [in order to get rid of their risk]."