Despite imprressive gains recorded by traditional market indices, the continuing attraction of hedge funds is not being overlooked as most strategies performed well in 2003
To date, 2003 has been a good year for hedge funds as an asset class. In the nine months to 30 September, the CSFB/Tremont Hedge Fund Index recorded a gain of 10.50% and returns from specific strategy indices were as high as 20%. However, in a year when traditional market indices have also recorded impressive gains, especially from their lowest points, there is a danger that the continuing attractions of hedge funds will be overlooked as long-only managers once again grab the headlines.
To be fair, it is not unusual for hedge fund returns, as expressed by the leading composite indices, to lag the major equity markets in periods of strength. This was certainly the case through the run up to the 1999 equity peak, but the ability of hedge fund managers to escape the directional pull of shares was amply demonstrated through the following three years when even the combined impact of WorldCom and Enron in 2002 could not prevent the major all- strategies index recording a modest gain.
One of the principal attractions often quoted for hedge funds is the ability to produce returns that are not correlated to equity markets. The opportunity to smooth portfolio returns and reduced volatility is an intriguing one for most managers of multi-asset portfolios, but now that we have seen signs of sustainable positive returns in equity markets, are we likely to be giving up too much by way of return in order to achieve this position? A brief overview of the 2003 performance of a number of important strategy areas to date would suggest this is not the case.
winners and losers
The most widely known hedge fund strategy is the long/short equity fund. This is an area that has attracted many established and successful long-only fund managers who see the opportunity to use their market timing and stock selection skills to the fullest extent without the constraints of benchmarks. As with most hedge fund strategies, this one can be played in many ways but, at the risk of generalising, many of these funds are seen as directional in that the natural long bias of many of the fund managers tends to see them perform better in positive equity market conditions. The evidence of the CSFB/Tremont series of strategy indices suggests that this is not necessarily the case. To 30 September the L/S index returned 9.92% compared to 14.71% for the S&P 500 and 16.96 for the MSCI $ World. This strategy is a major test of manager"s analytical skills and it is essential that they should be producing above average returns when conditions are so favourable.
A good example of this, where favourable market conditions can create excellent opportunities, is the performance of those funds operating in the emerging markets. Strong underlying conditions in South East Asia and Latin America have enabled managers to trade actively, and here we have seen annualised returns of 27% to date. This comes with a price however, annualised monthly volatility at a shade under 18% is one of the highest of any of the recognised strategy groups. Widely recognised as a high-risk strategy, emerging markets funds are not for the faint hearted even though they will probably continue to generate attractive returns for the foreseeable future.
One of the most successful strategies through the early part of 2003 has been that of distressed debt with the index recording a positive 19.17% through quarter one to quarter three. Twelve month returns were over 24%. From the third quarter of 2002, conditions were almost perfect for distressed debt managers. At that time, around one third of US issues were priced as distressed. The subsequent recovery in the broad economy and return of investor confidence has changed this picture dramatically and current analysis from Merrill Lynch suggests that this figure has fallen to under 10%. Early returns from managers for October indicate that opportunities are still out there but unless new issuance increases, it seems likely that many managers with high returns already in the bag may well adopt a more neutral stance as 2003 draws to a close.
Other event driven strategies have found life more difficult. Merger arbitrage has returned just 6.16% as deals have been few and far between and while we are just beginning to see an increase in corporate activity it seems likely that a combination of tight valuations, low interest rates and narrow spreads will keep returns low. Many event driven funds will be classed as multi-strategy and most of the leading participants in this sub-sector have concentrated almost solely on the credit markets.
The saviour of many fund of hedge funds through 2002 was convertible arbitrage where the negative sentiment in equity markets and positive action in credit enabled managers to secure high margins. The current year has proved more difficult as equity prices have improved and yield spreads narrowed in the face of rising dividend expectations. While the 8.9% return can be seen as reasonable, it masks a very difficult few months through the summer. However, as managers adjust to the improved conditions in credit markets and volatility increases, it seems likely that returns will improve.
Playing it safe
Among the more conservative strategies where it is normally possible to hedge out nearly all of the market risk, both fixed interest and equity market neutral have seen relatively low returns, 6.07% and 5.03% respectively. Unusually volatile conditions in the Treasury markets throughout Spring inhibited opportunities in the US, and those fixed interest managers with exposure in Europe and the Far East were better placed. The narrowing of spreads between high and low quality issues has inhibited the activities of more traditional equity market neutral strategies, a position, which has been further exacerbated by the influence of increasing numbers of long/short traders active in the market place. There are signs that these spreads are widening again as analysts dissect the progress of corporate recovery, and this should bring this favoured long-term strategy back in focus.
The past 12 months have also seen the rehabilitation of one of the oldest and perhaps the most well known of hedge fund strategies, global macro. Although this can incorporate any number of trading strategies, many of them un-hedged in the traditional sense, more recent opportunities have arisen in the currency markets where one-way traffic can often create massive shifts in exchange rates. Those with memories stretching back to 1992 will not need reminding how much can be traded in these markets. A nine month return of over 15% reflects the volatility which has been present this year and with the imbalance in most currency values against the dollar still evident, there is every prospect of this strategy continuing to feature. Interestingly, while this is widely perceived to be a high-risk strategy, and indeed history has shown that this can certainly be the case, the standard deviation of 12.2 is only just above that of long/short.
With most strategists anticipating a continuation of the current equity rally into 2004, there may well be a trend towards those managers, particularly long/short, who are seen to be beneficiaries of directional pull. While this may well prove to be the case, the need to be with the right managers is key given that the sector rotation and volatility within the main equity markets are likely to favour the traders rather than the position takers. As with many investment strategies, in the right conditions it is likely to be the higher risk funds, which attract the highest returns and for the moment both global macro and emerging markets look to be in a favourable position.
Apart from the high cost of entry direct investment into specific hedge funds, highly specialised research into both the effectiveness of the fund strategy and the abilities of the manager is required. Whereas most long-only funds will at least reflect market beta in positive conditions, there is no guarantee that a hedge fund manager will capture returns even in an apparent favourable climate. Whether single strategy or multi-strategy, a fund of funds approach has many advantages.
A review of performance of different hedge fund strategies suggests managers are not having to sacrifice return in order to reduce volatility and smooth performance.
Global macro and emerging markets strategies look to be in a favourable position.
There is no guarantee that a hedge fund manager will capture returns even in an apparently favourable climate.
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