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Hedge funds were supposed to be different

Created:

8 December 2008

Updated:

9 December 2008

Written by:

David Stevenson

Hedge funds were - at least in theory - supposed to be absolute return vehicles which would produce gains even in difficult and volatile markets. The whole marketing language of the sector has always been to compare annual returns from hedge funds using the language of 'cash plus 2 to 3 per cent per year'.

For some of the time, that language has been justified - from 1999 to the beginning of October 2008 the FTSE All-Share delivered a total return of minus 16.5 per cent, while the HFRI index of Fund of hedge Funds Composite delivered a total return of 57.9 per cent.

The reality for most firms in the past few months, though, has been very different - returns have crashed and hundreds of funds are now on the verge of closure as wealthy investors pull out their money, prompting a massive wave of panic selling in mainstream equity markets.

The table below - from the Credit Suisse Tremont index - captures some of that recent pain. It takes all the key sub-sets of the huge hedge fund universe and looks at returns for October as well as from the beginning of the year - overall the hedge fund universe has contracted by more than 5 per cent in October and just under 10 per cent for the year so far.

Managers in the convertible arbitrage sector (they use hybrid convertible instruments that mix debt and equity) have been worst hit with falls of just under 20 per cent this year, closely followed by emerging markets hedge funds and more traditional long/short equity funds (funds that invest primarily in equities but move between long and short positions).

Hedge funds implode

But even this big picture snapshot doesn't truly capture the pain inflicted on the most public parts of the hedge fund investment space. Winterfloods Research tracks the mixed fortunes of the listed hedge funds on the London market - these range from leading fund of fund hedge funds such as Thames River through to single manager funds such as BH Macro.

Overall the more popular multi-fund managers have experienced losses of 40 per cent year to date with Dexion Absolute and Goldman Sachs Dynamic Opportunities particularly badly hit. These huge losses from supposedly balanced funds - they tend to feature a wide array of underlying managers - has been accentuated by widening discounts to net asset value. Discounts to net asset values of between 20 and 25 per cent are not uncommon in funds such as Dexion Absolute and CMA Global hedge - although some hedge funds are still trading at a premium to net asset value including Opus Alternatives, and the Absolute Return Trust.

The listed hedge fund sector has been hit by unprecedented market turbulence - underlying performance has largely been dreadful, while discounts have opened up as investors have abandoned all perceived risky vehicles.

Exchange rate turbulence has also had an uneven effect, boosting net asset values for some, cutting net asset value (NAVs) for others. Even in the worst year before this, 2002, 31 per cent finished down, according to estimates from HedgeFundNet, yet this year 70 per cent of hedge funds had lost money from 1 Jan through to the end of September.

Some survivors

But some hedge funds have, by contrast, been performing remarkably well. One statistic stands out - one in every 50 funds is up more than 30 per cent globally.

In the listed fund of fund territory three funds stand out as relative top performers: FRM Credit Alpha (this focuses on credit market opportunities, its NAV over the past 12 months is down only 3.5 per cent), the Absolute Returns Trust (operated by the highly regarded Fauchier Partners LLP, which is in turn part owned by BNP Paribas - down 6.5 per cent over the last 12 months) and Dexion Trading (down 6.9 per cent).

Investors looking for the best recent performance should look closest at the single manager funds. Rather than sporting a variety of different asset managers, these funds feature just one management group but frequently include multiple fund strategies. Top dogs in this relatively small investment universe includes the giant Brevan Howard Macro fund (up 23 per cent in NAV terms), the highly specialised PSource Structured Debt fund (up 14 per cent this year) and the highly regarded Cazenove Absolute Equity fund - up 11 per cent over the past 12 months. Crucially excellent relative performance hasn’t necessarily been rewarded by narrow discounts - both BH Macro and Cazenove are trading at an 11 per cent discount to NAV.

The Future?

One possible indicator of future trends comes in a recent RBS analysis in their Alternatively publication. This featured a survey of hedge funds and asked managers to recommend their top investing strategies for 2009 - Macro and Long Credit strategies come out as top picks (41 per cent and 37 per cent of all votes) with all other investing strategies coming in with low single figures. This projection bodes well for funds such as BH Macro that play in these investment strategies.

It’s also worth noting that commodity trading adviser (CTA) hedge funds are expected to carry on performing strongly in 2009 - CTA managers use futures contracts to trade in everything from commodities through to foreign exchange. Some of the big firms such as Winton Capital have already had a good 2008 and are reporting strong fund inflows as more and more investors flock to this specialist space. Overall one key index of CTA strategies - the Barclays CTA index in the US - shows a year to date gain across all the funds in this space of 10.89 per cent with October showing gains of 3.55 per cent (2007 showed gains of 7.5 per cent and 2006 3.5 per cent).

On a larger scale the wave of restructurings might just be the tonic the sector needed - fund closures will focus investors attentions on the fitter, better placed and better capitalised managers and when markets do rebound, investors should expect long/short equity managers to start coming back into their own.