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’ $7 trillion, their impact on financial markets is similar.
In the accompanying articles Euromoney examines how hedge funds have moved from being peripheral players to the key drivers of many financial markets and vital to capital raising in the primary equity and emerging debt markets. We also profile some recent strong performers.
But at the very moment when hedge funds appear to have transformed the way money is managed, their performance is slipping and investors are re-examining the myths that have grown up around the industry. These include the notion that hedge fund performance is independent of traditional cash markets and that different hedge fund strategies are always uncorrelated with each other.
Old concerns are resurfacing, such as hedge funds’ reliance on leverage rather than smart investing to produce returns. Investors are also beginning to ask about survivor bias in performance figures – published figures tend to show returns for all hedge funds except the ones that have shut down. Style drift is also a growing concern as managers lose faith in their chosen strategy and seek to follow another in which they lack expertise. Poor internal risk management is another worry.
| Hedge fund asset flows Inflows/outflows ($mn) | |||
| Strategies | 1Q 04 | 2Q 04 | 04 ytd |
| Convertible arbitrage | 2,698.42 | 745.54 | 3,443.96 |
| Distressed securities | 840.84 | 818.85 | 1,659.69 |
| Emerging markets (total) | 1,242.40 | 1,235.03 | 2,477.43 |
| Equity hedge | 5,013.34 | 1,643.28 | 6,656.62 |
| Equity market neutral | 16.21 | -677.98 | -661.78 |
| Equity non-hedge | 980.17 | 842.23 | 1,822.39 |
| Event-driven | 2,819.08 | 890.77 | 3,709.85 |
| Fixed income arbitrage | 515.75 | -19.19 | 496.56 |
| Fixed income convertible bonds | 16.25 | 33.73 | 49.98 |
| Fixed income diversified | 665.81 | -243.57 | 422.24 |
| Fixed income high yield | 755.72 | 69.61 | 825.33 |
| Fixed income mortgage-backed | 1,692.06 | 550.66 | 2,242.72 |
| securities | |||
| Macro | 3,442.00 | 42.52 | 3,484.52 |
| Market timing | -123.92 | -75.57 | -199.49 |
| Merger arbitrage | -63.68 | 89.8 | 26.13 |
| Regulation D | 119.49 | 166.5 | 285.98 |
| Relative value arbitrage | 1,941.69 | 1,722.80 | 3,664.50 |
| Sector (total) | -344.7 | -384.37 | -729.07 |
| Short selling | -25.13 | 70.91 | 45.78 |
| Total | 22,201.79 | 7,521.54 | 29,723.33 |
| Source: Hedge Fund Research | |||
Big and bloated? 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”.
Those that have invested in hedge funds recently, that is over the past year, are the most disgruntled by recent weak performance and the most likely to pull their money out. Sophie Huang, project consultant at investment consultancy Scorpio Partnerships, says: “Those who have been in hedge funds for a while and truly understand the strategy and risks involved are taking the poor performance with a more laid-back attitude. Those who jumped on the bandwagon because they saw the returns are not very happy.”
Only relatively bad Hedge funds have lost money for the first time since July 2002. But it’s worth remembering that although the performance of hedge funds in the first half of the year has been decidedly lacklustre, it has certainly been better than the broad market indices. These also suffered in July and are negative to flat for the year to date.
For example, by the end of August, the S&P500 was down 0.69% for the year to date, the Dow Jones Industrial Average down 2.68% and the Nasdaq Composite Index down 8.25%.
In addition, the losses so far have been modest by the standards of recent down periods. According to HFR, a research and data firm whose Composite Index tracks 5,000 hedge funds compared with S&P’s 40 investable constituents, hedge funds experienced a maximum drawdown of 5.72% between July 2002 and April 2003. Amit Batra, senior hedge fund analyst at ING Investment Management in the US, recalls: “In summer 2002 investors lost confidence in the accuracy of financial statements of US companies. This was the time when WorldCom, Adelphia and others were restating their books due to fraud and inaccuracies in their balance sheet. This led to a large sell-off in the credit and equity markets.”
For the full year 2002, hedge funds were down 3.51%, according to Hennessee’s Hedge Fund Index. However, they still outperformed the equity markets, with the S&P500 Total Return Index down 22.19% for the year. They may prefer to be measured by absolute returns rather than relative to indices but this was in many ways a great result for hedge funds.
Hedge funds first began to struggle this year in April when better than forecast US employment figures led investors to expect imminent and rapid interest rate rises. What’s worrying is not so much the size of losses that accompanied the indiscriminate unwinding of the carry trade as their appearance across many different hedge fund strategies.
Kevin Heller, director of manager research at fund of hedge funds Focus Investment Group, says: “It’s been a particularly trying year for most hedge fund allocators because the correlation between strategies is very high.”
In fact, 12 of the 19 strategies on which HFR compiles quarterly information were down in the second quarter, compared with one in the first quarter. The last time HFR saw as many down strategies was in the first quarter of 2003.
This correlation between strategies and asset classes is unusual.
Andrew Gibson, investment manager at fund of hedge funds International Asset Management, says: “It’s been quite an unprecedented period. Over the past 12 months we’ve seen difficult bond and equity markets, volatility in currencies and uncertainty with interest rates.”
Although markets were difficult in 2002, with investors faced with a sharp drawdown in equities and a lack of liquidity, there were opportunities in other markets that enabled many hedge funds to perform. For example, there was a bull market in bonds and there were interesting opportunities in convertibles because corporates couldn’t raise cash in the equity markets. In 2002, convertible arbitrage funds were up 9.05%, according to the HFRI Convertible Arbitrage Index.
Limited volatility Hedge funds have also been affected by the fact that volatility levels have been at their lowest for some time and there has been a lack of clear trend in the markets. “There is no period I can remember when volatility has been so low across the majority of strategies,” says Heller.
The CBOE Volatility Index (VIX), which measures the volatility implied in option pricing on the S&P500 and is considered one of the best measures of equity market volatility, shows that volatility is down almost 25% from the end of 2003 to the end of July 2004. In January, the VIX dipped below 15% for the first time since the mid-1990s. The index reached its low point of 13.76 on July 14. Since the mid-1990s the VIX has typically been between 20% and 30%.
Volatility in the bond market has also been low. The UK Government Bond Index, for example, shows that for the year to end of July volatility has been 3.7%, according to Thomson Financial Datastream. This is down from 4.3% in 2003.
Hedge funds thrive on volatility. But their operations tend over time to transform the markets in which they deal and they are now at such a size as to reduce volatility themselves. For example, in falling markets hedge funds short stocks in order to benefit from the drop in prices. They then have to buy the stock to cover their shorts, which drives up prices, thereby limiting the trough. Chris Woods, head of hedge funds at State Street Global Advisors, says: “In many ways hedge funds are disguised volatility sellers. Essentially, they short puts on the market.”
Not surprisingly, as hedge funds have been losing money, investor enthusiasm has waned and inflows into hedge funds tailed off in the second quarter. The Hedge Fund Research Composite Index shows that net investment fell from an average of $20 billion a quarter for the past year to $7.5 billion in the second quarter this year. Several hedge fund strategies actually posted outflows during the quarter.
Is this a sign of things to come?
Both the historical performance of hedge funds and expectations of performance by investors have been overblown and this partly accounts for the record inflows in 2003. Andy Maguire, financial services partner at Boston Consulting Group, says historical performance doesn’t take into account the funds that closed down. That is, most index performance figures are skewed by the fact that they drop funds that blow up and so return data are inflated by what is known as survivor bias. Watson Wyatt’s Brown says: “If someone invests in a fund of funds, the realistic expectation is around 6% over cash rates but not double-digit returns.”
Recent poor performance should not come as a shock to investors with long experience in placing money with hedge funds, whose performance has been patchy over the past few years.
Nothing odd about drawdowns Only five out of the past 10 years have delivered double-digit returns according to the CSFB/Tremont Hedge Fund Index. And losses are hardly unheard of.
HFR’s Nicholas says: “If you look at HFRI there have been 12 drawdowns [periods] since 1990.” These have ranged from 1.6% to 11.42%. “This drawdown is around 2% now, so it ranks in the bottom third of drawdowns.”
May 1998 to March 1999 was the worst drawdown period for the HFRI hedge fund index since it began in 1990, at 11.42%. The drawdown from April to July 2004 is the sixth drawdown period since then and the bottom ranked at 1.79% (see chart). “There’s a misperception in the marketplace that hedge funds always make money,” adds Nicholas.
Many feel that the recent weak performance could even work in the hedge fund industry’s favour. “It may take some heat out of the market. A period of lower returns might lead to a shakeout and free up capacity for long-term investors [in hedge funds],” says Watson Wyatt’s Brown.
It should also help to sort the management wheat from the chaff. “There ought to be some natural selection,” says a fund of funds manager. “Maybe the tide has to go out to see who isn’t wearing a swimming suit. It’s clear a lot of hedge funds don’t deliver what they’re supposed to deliver and probably some will fail.”
The rising number of hedge funds offered by both independent firms and traditional money managers, along with investor appetite, has caused growing pains for the industry.
Too many new entrants Traditional asset management firms have been making a big push into hedge funds and many are already heavily invested. Scorpio’s Huang says: “A lot of the traditional managers have also been spooked by [New York state attorney general Eliot] Spitzer and are jumping into hedge funds because there is less scrutiny, more flexibility and that’s where the fees are.” For example, in August UBS Global Asset Management announced that 71% of its institutional inflows in the second quarter went into its alternative and quantitative business.
Substantial inflows in the first quarter this year and the last quarter of 2003, in addition to the difficult market environment, mean that hedge fund managers have had trouble identifying profitable positions for these funds. Focus’s Heller says: “It’s logical that as the hedge fund industry grows, the inefficiencies get less and returns come down.” He adds: “All things equal, a good manager will do better with less money.” Maslinski adds: “If everything was in hedge funds it could be self-destructive.”
At the extreme, some managers now wonder if the proliferation of investment using hedge fund strategies is not ultimately self-defeating. It’s not just a question of the increasing number of hedge fund managers leading to overcrowded trades. Neal Berger, president of multistrategy hedge fund Apogee, ponders: “Where has all the dumb money gone? Mutual funds used to be good meat for hedge fund managers but now everyone’s a hedge fund manager.”
This complaint, from one of the most innovative managers, brings to mind the old market saying that if you don’t know who the market fool is, watch out – it’s probably you.
Berger is not alone in his concern about the sustainability of hedge fund returns and the finite talent pool. Jean Karoubi, founder of fund of funds advisor the LongChamp Group, says: “Hedge funds are no fun any more as potentially good and bad new managers can equally raise money and close very fast if they have a good start-up performance. There is often no time to figure out who is just lucky and who is actually good. So doing professional due diligence work with managers until you are confident in their ability to generate alpha is something of the past and you now have to make investment decisions without enough knowledge.”
E Lee Hennessee, managing principal of Hennessee Group, says: “We have found that we have to interview more managers, approximately 20% more, than we used to, in order to find the quality ones.”
Of course, if everyone is now a hedge fund manager, not all of them can be good ones.
At the very least the rapid pace of inflows into hedge funds must reduce returns even if it does not presage the doom of hedge fund investing. Because of trading costs, managers would not necessarily add to existing positions in funds bloated by new inflows even if they were comfortable holding on to them for the existing assets, and the resultant higher cash holdings would act as a drag on performance.
Struggling strategies
A degree of bloating in terms of ability to put money to work profitably can be seen with recently beleaguered hedge fund strategies such as merger arbitrage and convertible arbitrage. Convertible arbitrage is one of the top five strategies by size, with about $48.48 billion, about 5.6% of total hedge fund assets at the end of the second quarter. The strategy has grown by almost 50% since 2002. Merger arbitrage is less popular, with total assets of $14.19 billion million, but is well known for having a limited opportunity set.
Both strategies have been struggling and have suffered a slowdown in inflows. The HFRI Convertible Arbitrage Index was down 0.88% for the year to end-July, while merger arbitrage was the worst-performing strategy to the end of July, down 0.36%. According to HFR, inflows to convertible arbitrage strategies were $745.5 million in the second quarter this year compared with $2.7 billion in the first quarter. Merger arbitrage inflows were $89.8 million in the second quarter compared with outflows of $63 million in the first quarter.
In the third and fourth quarters of last year M&A deal flow looked set to pick up but has since tapered off again, which means that merger arbitrage managers could continue to struggle. M&A deal flow has dropped from $553 billion in the first quarter this year to $423 billion in the second quarter, according to Dealogic. Harold Yoon, who runs the fund of funds business at ING Investment Management, says: “Unless [M&A] deal activity picks up later in the year and the deals are big deals, for example $30 billion, returns will remain low.”
A $30 billion deal, he says, would be big enough to withstand having arbitrageurs significantly affect the difference between the current stock price and the final takeover price, known as the spread. But the spread on a low-risk $1 billion deal would be very tight and the opportunity to benefit from the arbitrage trade would quickly disappear.
Even on the $58 billion deal between JPMorgan Chase and Bank One the spread collapsed very quickly earlier this year. “I would note that even for very large deals, if there is sufficient capital to be put to work, the spreads can tighten very quickly,” says Yoon. He adds: “I think the reason for this [in the case of JPMorgan and Bank One] is that while this was a large transaction, it was one of the few big ‘safe’ transactions at the time. Therefore, more or less everyone invested in the deal.”
Style-drift worries
Convertible arbitrage is also suffering from overcrowded trades and has been one of the worst performers this year so far. The primary investors in convertibles are convert arb hedge funds. They invest in bonds they think are undervalued compared with the stock and short the stock. Van says: “There are a finite number of opportunities and an increasing number of people pursuing them.” He adds: “The more people who buy the undervalued stock the less it’s undervalued.”
As a result of particularly difficult conditions for this strategy – low volatility and light issuance – convert arb hedge fund managers are expanding into other strategies to create a multistrategy business. This move has been popular for many hedge funds that started as single-strategy funds. “The most common style drift we see today is from the merger arbitrage and convertible arbitrage strategies,” says ING’s Batra.
Merger arbitrage funds are also expanding into credit strategies. Batra says: “We are seeing merger arbitrage funds begin to focus more on credit and distressed strategies and also special situations – non-merger arbitrage equity plays.” He adds that when there is a lot of distressed debt business there is generally not a lot of merger business, and vice versa.
Funds of funds, however, are wary of hedge funds drifting away from their stated strategies. “Style drift is something that we – and hopefully all funds of funds – monitor very carefully… we are concerned about style drift,” says Batra. He adds: “While we understand the desire of hedge fund managers to go ‘where the money is’ given the compensation structure of hedge funds, it is important for a fund of funds to be well diversified in terms of strategies. This can lead us to redeeming on managers who stray too far from their expertise.”
Earlier this year ING’s fund of funds withdrew its money from a merger arbitrage manager who shifted his portfolio into credit strategies. “If we want additional credit exposure, we can find a superior credit strategy manager that has the expertise, background and team to manage that strategy,” says ING’s Yoon.
In addition to concerns about style drift, some hedge fund investors worry that many managers have compromised internal risk controls. “While traders moved out of banks to start hedge funds and investors replaced bank capital, the independent risk management oversight at the banks did not move over,” says Yoon at ING. Although many hedge funds have employed their own risk managers, these risk managers work for the hedge funds and lack independence. Therefore, there may be a conflict of interest. “As a fund of funds, I think an important role we play is to carry out the independent risk management function on behalf of our investors,” Yoon adds.
Independent risk management oversight can protect investors by verifying the proper pricing of portfolios. “The mispricing of portfolios has been behind a number of hedge fund blow-ups,” says Yoon. For example, mortgage-backed hedge fund Beacon Hill Asset Management is currently in litigation. In November 2002 the SEC alleged that “at least during July through September 2002, Beacon Hill reported net asset values and corresponding returns to fund investors that it knew or should have known were materially overstated”. Former portfolio manager for Lipper convertible arbitrage hedge funds Edward J Strafaci is also being charged currently by the SEC “for overstating the value of the funds”.
Looming leverage crisis
Another effect of weak hedge fund performance is the temptation to increase the degree of leverage in a fund. LongChamp’s Karoubi says: “The industry cannot continue this way and most likely there will be a crisis, and there could certainly be some kind of domino effect if there are large unexpected losses, which would be magnified by the redemptions from leveraged structures.”
In May, Barry Colvin, president and CIO of fund of funds Tremont, told Euromoney: “Returns have come down a little bit and volatility is low so people seem to think that you can simply leverage two times, three times, or whatever, and extrapolate the return without any consideration for the risk involved.”
Fund of funds manager Heller at Focus is also concerned about overleveraged hedge funds. “If a strategy can’t make money in its own right, it’s not necessarily going to work to add leverage.” If a manager is more prone to down months, the use of leverage will only serve to amplify these poor returns.
Heller, whose firm avoids investing in overleveraged funds, highlights mortgage-backed securities arbitrage – which is primarily US-based and attempts to profit from price anomalies between MBS – as a particular strategy that’s predisposed to leverage.
“Mortgage arbitrage has transparency issues, liquidity issues and funds are often invested in leveraged instruments that are leveraged themselves.” This strategy attracted $2.24 billion in inflows in the first half of 2004, according to HFR. Heller adds: “As the industry grows the question of leverage will become more of an issue.”
In May, Euromoney highlighted the concern that hedge funds of funds were getting in on the leverage act as well. In June, the Bank of England’s Financial Stability Review also stated that funds of funds were using leverage to enhance returns. Gavin Rankin, Europe product manager at Citigroup Private Bank, says: “Diversified funds of funds are down 9% and the only way they could be down that much is if they have around 4% to 5% leverage in the structure.”
Although 4% to 5% pales in comparison with the 17 times leverage used by LTCM at the end of 1994 and 28 times at the end of 1997, it is still a cause for concern.
Gibson at fund of funds IAM, which does not use leverage, says: “It’s increasingly becoming more of an issue especially for funds of funds.” He says this is because hedge funds and their lenders learnt an important lesson in 1998. “[Hedge funds are] more disciplined and banks are aware of the risk of lending to hedge funds. But, funds of funds are feeling the pressure due to the low-yielding environment we’re operating in, and money is so cheap to borrow,” he says.
According to Gibson, the fund of funds proposition is to generate a long-term return with the right level of risk for the client. “The problem is there are [other funds of funds] trying to force something into being a leveraged product, something that’s not meant to be leveraged. They are trying to create a product to suit the environment.”
Rankin feels that the increase in the cost of borrowing will dampen the general level of leverage in hedge funds a little. “As interest rates rise, leveraged hedge funds will have to make even more money to make it worth borrowing.” Of course, this could just mean that they borrow even more.
A squeeze on fees
Weak hedge fund performance should eventually lead to downward pressure on the large fees for which hedge fund managers are renowned. Sheila Nicoll, deputy chief executive at the Investment Management Association, says: “I think the industry probably will be looking at fees. As things become less happy, people will be asking if it is worth it.”
For now, the best fund managers might continue to benefit from the impression of scarcity, convincing investors that they should count themselves lucky just to get their money into the top funds. It’s a psychology familiar to any student of market manias and collapses.
Fund of funds managers say that those that perform will be able to charge higher fees. Most hedge funds usually charge somewhere in the region of 1.5% management fee and 20% performance fee above a certain benchmark.
Some funds have even been able to structure their fees at 3% and 30% or 0% and 50%. One fund of funds manager says: “They [hedge funds] are willing to provide capacity but you have to pay a premium for the superior track record.” For example, macro hedge fund manager Caxton Associates, one of the largest hedge fund managers globally with around $10 billion in assets under management at the end of 2002, raised its fees to 3% with a 30% performance fee. So that’s a 3% fee before they’ve even made the investor any money. If you applied that 3% management fee to the whole fund, it would imply annual revenues of $300 million just for bringing in the cash and sitting on it.
Such management fees aren’t going to be enough to allow a group of Wall Street traders leaving to set up a $50 million hedge fund to sit back and take it easy. But the top five hedge fund launches in the US in the first half of the year have managed to start with more than $500 million: for example, Black River ($1.3 billion), Ospraie ($1.2 billion) and Highbridge Event ($500 million), according to Absolute Return magazine.
Even the average size of funds globally is around $150 million. So that’s $2.2 million at 1.5% and $4.4 million at 3%.
One year’s management fees on such a fund might not count as untold wealth to hedge fund managers but some investors are asking if there’s a particular period after which a hedge fund manager’s enthusiasm for doing the hard work is likely to dim.
BCG’s Maguire says: “A couple of people have got it that some people are not in it for the long term. Either the idea itself has a limited time window or once the guy running it has $20 million in the bank his motivation wanes.” Eugenio Verzili, managing director at fund of funds Focus Investment Group, says: “Between the first and fourth year is when hedge funds outperform, because they’re hungry.”
A study done by Lazard in November 2001 shows that the incremental monthly return of hedge funds is positive between 1 month and 3.5 years.
A tightrope over a minefield
The state of the hedge fund industry is such that managers are being forced to seek out some increasingly obscure ways to make money and to generate returns that distinguish them from their peers. LongChamp’s Karoubi says: “Right now only niche strategies associated with high risk can create some kind of excess return. But, it is like walking on a thin thread above a minefield, not above a gold mine any more. The gold is very difficult to find.”
Euromoney has previously reported on Aquila Asset Management (see November 2003 issue). Now called Apogee, it’s a firm that prides itself on its desire and ability to be innovative. Apogee’s Berger says the most obscure strategy his firm is currently engaging in is called ECN rebate trading where the fund provides liquidity for ECNs. This strategy is included in the firm’s $100 million multistrategy fund. The firm has developed a black box to passively trade eight million to 10 million shares a day for a $2 rebate for every 1,000 shares. It costs the firm 65 cents per thousand to clear the trades. Therefore, net profit is $1.35 per 1,000 shares traded without accounting for any profit or loss. However, Berger says capacity is limited. “You can only trade big, very liquid stocks. $2.5 million a year on a nominal basis is our estimate on what you can earn on this strategy.”
The ECN rebate strategy contributes about 2% to the overall performance of the $100 million multistrategy fund. It’s not the kind of endeavour to generate a fortune on a large fund.
A very different activity that is becoming more popular is for hedge funds to take on a bank’s trading book risk. Alastair Beattie, head of SG CIB’s Hedge Fund Group’s London sales, says: “We are generating risk through our structured product trading and a hedge fund can take on that risk and free up our capacity.” This could be an equity hedge fund or a credit hedge fund, depending on the type of risk. For example, an equity hedge fund could take on equity volatility and a credit hedge fund could take on the bank’s credit risk.
A credit intermediation role
In addition to their impact on financial markets, hedge funds are also having a direct effect on the real economy, in some cases taking on the credit intermediation role once performed by banks.
For example, the use of the Regulation D strategy in the US is becoming more popular and plays an important role in keeping smaller companies afloat. Hedge funds using this strategy invest in small-cap public companies raising money in the private capital markets. Charles Gradante, CIO of Hennessee Group, says: “Multiple arbitrage managers are getting into mezzanine finance/private placements.” He adds: “These opportunities are being created by banks moving away from lending to small-cap public companies due to the higher risks and associated loan reserves.”
In fact there is concern that this is one area where compulsory registration of hedge fund managers, as proposed by the SEC, could hinder hedge fund activity. “The reason we don’t want these funds to register is because it’s difficult to price the loans they’re making,” says Gradante. He believes that regulation would make it more complicated and less likely that hedge funds would employ this strategy. This would, in turn, affect the ability of smaller companies to fund themselves.
There is no doubt that hedge funds now play a significant and increasing role in the financial markets. The IMA’s Nicoll says: “I don’t think there’s any doubt that hedge funds are here to stay, but there’s a view that they need to be seen in context.” She adds: “There’s quite a balanced view [among investment managers] that, yes, they [hedge funds] do have their place but we must be wary of them being the great new vogue. Realism has crept in after extremely good performance [and investors are recognizing] that hedge funds are settling down now.”
Despite the fact that hedge funds have not always delivered high returns to investors and are still suffering the teething problems that come with over-rapid success, they have managed to limit the downside and deliver good returns over the longer term. Keeping in mind the possible distortion of survivor bias, statistics show that since 1990 hedge funds have delivered an average annualized return of 14.4%, with a standard deviation of 7 and a Sharpe ratio of 1.3. This compares with an annualized return for US equity mutual funds of 11.18% from 1990 to the end of 2003, according to Lipper. HFR’s Nicholas says: “Hedge funds perform well because they preserve wealth in this kind of environment and deliver more consistent returns over the long run.”
For now hedge funds are suffering a rough period and the shine has come off their ability to produce double-digit returns. But if global stock markets continue to perform poorly amid rising oil prices, growing twin US deficits, doubts over global economic growth and the resilience of the US consumer, hedge fund managers could once again get the chance to prove their worth: against the backdrop of a bear market.
Euromoney profiles a number of hedge funds that have been storming ahead this year despite difficult conditions. One characteristic these managers share is long experience.
| Total assets by strategy ($mn) | ||||
| Strategy | 2002 | 2003 | 1Q 04 | 2Q 04 |
| Convertible arbitrage | 32,832.80 | 44,712.90 | 48,368.80 | 48,477.30 |
| Distressed securities | 29,279.30 | 35,555.70 | 37,572.50 | 39,149.40 |
| Emerging markets (total) | 13,365.00 | 22,268.00 | 25,175.80 | 25,412.40 |
| Equity hedge | 197,840.20 | 241,919.80 | 258,031.20 | 256,193.30 |
| Equity market neutral | 18,456.40 | 19,648.30 | 20,062.40 | 19,531.20 |
| Equity non-hedge | 24,815.90 | 34,089.50 | 37,130.90 | 37,803.60 |
| Event-driven | 75,603.90 | 100,800.10 | 107,480.70 | 109,081.50 |
| Fixed income: arbitrage | 12,944.40 | 18,057.80 | 18,703.90 | 18,990.60 |
| Fixed income: convertible bonds | 516.6 | 681.7 | 735 | 755.3 |
| Fixed income: diversified | 11,685.80 | 14,925.40 | 16,164.60 | 15,650.40 |
| Fixed income: high yield | 1,513.20 | 2,425.80 | 3,243.40 | 3,308.80 |
| Fixed income: mortgage-backed securities | 15,785.40 | 19,973.60 | 22,191.80 | 23,086.30 |
| Macro | 58,547.90 | 102,456.80 | 107,991.60 | 104,693.80 |
| Market timing | 3,774.20 | 3,829.30 | 3,792.40 | 3,719.80 |
| Merger arbitrage | 12,613.70 | 14,572.30 | 14,284.70 | 14,192.10 |
| Regulation D | 897.5 | 963 | 1,140.30 | 1,346.90 |
| Relative value arbitrage | 74,295.30 | 98,590.60 | 102,339.50 | 104,769.80 |
| Sector (total) | 35,156.80 | 39,704.60 | 38,512.20 | 37,817.40 |
| Short selling | 2,380.10 | 1,834.00 | 1,751.60 | 1,923.70 |
| Total assets | 622,304.20 | 817,009.30 | 864,673.30 | 865,903.70 |
| Source: Hedge Fund Research | ||||
| Drawdown periods for the HFRI fund weighted composite index Ranked by maximum drawdown since index inception in 1990 | |||||||
| Start period | End period | Recovery (in months) | Maximum drawdown | Next six months from maximum drawdown | Next 12 months from maximum drawdown | Next six months from recovery | Next 12 months from recovery |
| May-98 | Mar-99 | 10 | 11.42 | 9.62% | 23.94% | 9.80% | 36.06% |
| Sep-00 | Jan-02 | 16 | 6.39 | 4.77% | 4.99% | -3.30% | -1.24% |
| Jun-02 | Apr-03 | 10 | 5.72 | 3.34% | 16.19% | 12.23% | 18.06% |
| Aug-90 | Mar-91 | 7 | 5.38 | 15.89% | 29.50% | 14.06% | 31.38% |
| Apr-00 | Aug-00 | 4 | 4.75 | 0.15% | 4.92% | -3.40% | -2.86% |
| Feb-94 | Sep-94 | 7 | 2.63 | 5.73% | 9.43% | 0.58% | 14.75% |
| Oct-97 | Feb-98 | 5 | 2.45 | 5.33% | 0.71% | -7.89% | 0.97% |
| Jan-90 | Mar-90 | 2 | 2.11 | 11.87% | 10.89% | 1.05% | 15.51% |
| Apr-04 | Jul-04 | 3 | 1.79 | N/A | N/A | N/A | N/A |
| Mar-97 | May-97 | 2 | 1.75 | 14.11% | 21.60% | 8.30% | 14.07% |
| Oct-94 | Mar-95 | 5 | 1.6 | 13.09% | 25.29% | 14.43% | 24.96% |
| Source: Hedge Fund Research | |||||||
