Report Sees ‘Substantial’ Opportunities for Hedge Funds in 2011

Dec 21 2010 | 11:03am ET

File this one under: silver linings. Morgan Stanley Smith Barney says the financial crisis has “thinned” the number of hedge funds in the market, thus lessening competition, thus opening up opportunities for those still in the game.

In addition, says the financial services firm in its latest Global Investment Overview, other market participants (whether banks or individuals) have cut back their risk exposure, reducing competition in the sector further. Assets under management in the hedge fund space have substantially recovered, but borrowing is down dramatically. The result, according to the report, is “an attractive environment for ‘alpha’ generation.”

Other factors affecting the hedge fund space in 2011 will include the slow recovery in the credit markets; increased risk-taking by hedge fund managers; increasing dispersion of manager results; “dislocation benefits” arising from persisting macroeconomic uncertainty in some parts of the globe; and the ongoing regulation of the space (in particular, the fall-out from the current insider-trading investigation in the U.S.).

Having outlined the trends, the report goes on to consider the corresponding tactical positions within hedge fund strategies. In the equity long-short area, it says, fundamental stock pickers are likely to find “substantial” opportunities, in part because the level of interstock correlation is substantially above the long-run average. Government policies in sectors like finance and health care will also create investment opportunities. In the event-driven area, the financial services specialist expects a continued shift “from the long-credit opportunity to the alpha side.”

“During the last 18 months or so, managers have made substantial gains by following the compression in credit spreads. While average spreads are substantially off their peaks, managers have shifted to get involved in attractive risk-reward opportunities related to specific restructurings and workouts. Managers in this area will face a continuing and potentially growing supply as debt matures and deleveraging continues to work its way through the system,” says the overview.

Morgan Stanley Smith Barney says 2011 will also bring big opportunities for equity-oriented, event-driven managers. Merger activity will pick up, says the report, especially in the second half of the year, as liquidity returns to the market. “If markets and the economy continue on even a modest path to recovery, corporations will put their cash balances to work in consolidations, providing a tailwind for post-reorganization equity and merger-arbitrage strategies.”

The overview also suggests that ongoing policy action, economic stress in “core” and “peripheral” Eurozone countries, and the effects of loose monetary policy calls for the overweighting of global macro strategies next year. “More generally, volatility in aggregate markets tends to support these strategies, giving opportunities for managers to generate exceptional returns.”

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