As the hedge fund market matures product providers and investors must learn not to expect the stella...
As the hedge fund market matures product providers and investors must learn not to expect the stellar double digit returns of the 1990s, according to Derek Stewart of Mellon Global Alternative Investments. During the 1990s, hedge fund returns across a broad range of strategies averaged 18.3% annualised but during the period January 2000 to July this year the equivalent figure has been 7.1%
Stewart said: "We can see how strong they were in the late-1990s but this was a golden period for investing and it set everyone's expectations too high. You can see this with strategies like long/short equity and macro; typically these strategies are directional and they rode the equity market wave. They were generating lots of the returns from beta, not alpha and in a downward environment, those strategies don't perform as well.
"During that period it was very easy to make 10%-15%pa regardless of strategy selection. You didn't realise it at the time but it was a very good period. If we compare that to traditional markets, hedge funds significantly outperformed other asset classes in those periods. One reason is that there were many fewer hedge funds in those days; the structure allowed them to exploit many more inefficiencies; and they were specialists - they had more freedom."
While returns have been coming down, he stressed the hedge fund industry is still managing to generate real gains for investors and to beat equities, high yield, government bonds and the returns available from cash deposits. The 7.1% a year over the period 2000 to July 2005 compares with 1.3% from the MSCI World Index, 6.5% from the Merrill Lynch High Yield Master Index, 7% from the JP Morgan Global Government Bond Index and 2.8% from US interest rates.
Stewart added: "What is not included in those figures is the benefits you get from lower correlation and lower risk. In my mind hedge funds are the purest form of active management and they will continue to offer these benefits going forward. I just think we have to be slightly more realistic with our return objectives."
Mellon has identified a number of reasons why rates of investment return are lower generally. "We've been in an environment of low interest rates," Stewart said. "Volatility has declined; and companies have been deleveraging, which means they haven't been taking so much risk, which compresses volatility. Sectors and markets have become more global so we've seen less dispersion regionally than there was historically.
"Also, technology in the last few years has meant that everyone has access to the same information. If you look at some of the hedge fund strategies historically, it was the information edge that created the advantage. The managers were able to get information before other people, and that edge has largely gone."
According to Mellon, hedge funds have some specific reasons why their returns have been coming down, not least because a huge amount more money has been coming in to the sector, compressing returns. Between January 2003 and June 2005 the hedge fund industry's assets rose by some 240%, and are now in excess of $700bn, according to Tass figures.
Stewart said: "We've also seen in areas like arbitrage, that there are limited inefficiencies and you can get crowding out if everyone is pursuing the same trades. We've seen more hedging instruments. You can now hedge almost any risk you want because derivative markets have developed. But if you hedge more risks, it costs you more and that reduces your upside as well."
This combination of assets coming in at a time when strategies were failing to deliver in line with returns from the previous decade has been a problem, Stewart said, and he predicted growth for some strategies will slow, and in some cases, he noted, has already begun to reverse.
Despite this, Mellon remains bullish on the outlook for the sector overall. Stewart said: "The hedge fund opportunity set has changed. Hedge funds will continue to evolve and find inefficiencies. A large part of what they are doing is taking advantage of rules-based investors. If someone has a specific mandate where they have to be only in investment grade bonds, say, and something like GM or Ford is downgraded, hedge funds will step in and take advantage of that dislocation because other owners of those securities are forced to sell.
"We're also seeing more talent be attracted to this area. More and more long-only managers want to run unconstrained portfolios because they can generate better risk-adjusted returns."
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