Hedge funds up, but all is not rosy

Financial Times – Published: July 19 2009

Hedge funds have made money this year. This is a gratifying change compared with last year, but there remains a nasty possibility that it will do them little or no good.

Measuring the performance of the hedge fund industry as a whole remains a maddeningly inexact science, which if anything may be getting harder. Hedge fund indices are proliferating, while the number of funds – thanks to last year’s disaster – is dwindling. In the process, “survivorship bias”, the phenomenon that overall results will be skewed positively by the fact that funds that failed to survive are no longer part of the data, becomes more of a problem.

That said, the broad picture of the first half of the year is that hedge funds did well, and generally beat stock market indices and cash. Neither was a difficult hurdle to clear, but this still suggests hedge fund managers – who generally beat stocks last year but came nowhere near beating cash – have a case to show to investors.

Key numbers are as follows. More or less every indexer seems to agree that the “average” hedge fund made gains for the first six months. Given the wide variation in definitions they use, they were in surprisingly strong agreement.

HedgeFund.net puts that return at 9.23 per cent, against a 3.16 per cent return for the S&P 500. This made it the best outperformance of equities, in a half when equities were up, in nine years. Absolute Return put hedge funds’ average return at 6.3 per cent, while Eurekahedge put the figure at 9.4 per cent, as did Hedge Fund Research of Chicago.

Strategies that followed emerging markets did best, but so did a range of other strategies, notably in distressed debt.

The question is how many investors benefited from them. Many investors got out of their funds, under duress, just as their managers were pulling things around. It is far from clear that they will be able to re-enter any time soon.

Research by Huw van Steenis of Morgan Stanley suggests the greatest wave of hedge fund redemptions is over, having brought the total assets of the sector down from $1,930bn (£1,173bn, €1,369bn) at the beginning of last year to about $1,330bn at the end of this March.

The second quarter saw some of the bigger established hedge fund groups enjoying small net inflows. Private clients, the traditional bedrock of the sector, appear not to be getting back in in any great numbers, while there are some signs that institutions may be doing so. In both cases they will be guided by investment appetites and necessity – many may still not have the funds to commit.

All of this leads to a sad paradox for the hedge fund industry. The sudden departure of so many funds that were dedicated to finding and exploiting misvaluations, and of cash from the funds that survived, means there will be more misvaluations. They may well be more egregious than before.

The lack of other funds playing in the space will also mean that surviving funds can fill their boots without running the systemic risks they unwittingly took the last time around when they found themselves in many “crowded” trades.

But all is not rosy. There may be a lot of gaping misvaluations waiting to be corrected at present, but other things are lacking. There have been no clear macro trends during the first half. With deep uncertainty over the direction in which the world economy is headed, unbalanced bets would be unwise and risky.

And historic patterns have been so disrupted that classic quantitative stockpicking, buying undervalued stocks and balancing these positions by selling short overvalued stocks, appears not to be working.

The difficulties for certain strategies underscore this. Both commodity trading advisers and market neutral managers have lost money this year. While these models are not working, it will be all the harder to persuade money back into them.

Further, with leverage strictly rationed, it will be harder to deliver the returns that hedge funds used to enjoy.

This is not like the “great moderation” in the middle of this decade, when hedge funds used ever more borrowed money to pile into the same positions that carried the same dwindling but still positive returns.

But the central point remains. This should be a good period for a lot of the strategies that have suffered the worst hit to their reputations over the past two years. But precisely because of that hit to their reputations, they may find it difficult to persuade wealthy investors, or big institutions, to give them the money to go out and exploit that opportunity.

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