Hedge Funds: Perhaps Their Recovery Was Too Easy

Dec 9 2009 | 10:00am ET

By Rickard Lundquist, Portfolio Specialist, SEB Private Banking -- Hedge funds continued to rise sharply in value during the third quarter of 2009, but early in the fourth quarter they showed a small decline in overall returns, according to the HFRX Global Hedge Index. In contrast, the Credit Suisse/ Tremont Index rose marginally (see table below). 

The second half of October was a little tougher, with downturns almost across the board as market worries mounted. Volatility as measured by the VIX index rebounded towards 30, making it generally harder for hedge funds to perform well. Since early November, volatility has again subsided, with the VIX dropping to a low of around 20. This index is thus close to its long-term average, and very far from its peak of around 80 during the crisis of last autumn and winter.

After more than six months of genuinely good returns and a comparatively easy market for nearly all hedge fund strategies, a change may occur as normalisation continues and corrections take place. In one-way markets − like the steady rise so far this year − less qualified hedge fund managers unfortunately take many long positions. Even though these managers are not so skilled at handling portfolio hedges, they have still been able to report good value appreciation. The question is whether the recovery has been too easy.

(Click Chart to Enlarge)

For less skilled managers, our assessment is that the hedge fund market has been too easy. They should instead have been forced out of the market (the very worst are already gone, however). Genuinely skilful managers, however, have good potential ahead. They have continued to hedge the downside. There is consequently a risk that these managers may have achieved relatively poor value appreciation this year. Yet history shows that high-quality managers come out as winners in tougher times. Last year’s crash illustrates this with dramatic clarity.

Good Opportunities For Hedge Funds

The large adjustments that have occurred during 2009 in order to normalise prices have been extraordinary, and they should also be viewed as such. It is now time to lift our gaze and look beyond the present, focusing instead on more long-term, reasonable trends. Although the first lucrative recovery phase is over, hedge funds should have several years of better than normal returns ahead − especially the high-quality funds.

We have a neutral view of Equity Long/Short (L/S) as a whole. Funds with genuinely high-quality managers remain attractive, however. We are choosing to try to focus on managers who possess knowledge and common sense and do not follow the herd. Those who merely go along with the majority will eventually have a rough time.

There are special reasons to comment on Emerging Markets L/S, since it is important to be aware that in some cases hedging is hard to achieve, and in most cases it is rather expensive. This category is thus more similar to ordinary equity investments than are other Equity L/S funds. These investments may still be attractive, however, but we must not forget their different characteristics.

As for Fixed Income, we favour Credit L/S and Fixed Income directional plays, while we are currently trying to avoid Relative Value. The Convertible Arbitrage strategy has had a fantastic 2009, recouping virtually its entire loss of value from last year. But prices have essentially been normalised, which means that we now have a neutral view of Convertible Arbitrage.

In Distressed strategies, we also foresee good opportunities for L/S, but we are more neutral towards long-term strategies. Yield spreads in High Yield have narrowed greatly during 2009. As a result, certain individual investments (companies) have followed the trend towards narrower yield spreads without having genuinely qualified for this at the company level. Those managers who can manoeuvre properly with long positions against hedged short positions have good potential to generate fine returns ahead.

Event Driven and Merger Arbitrage are becoming attractive, since a growing number of structurally motivated company transactions are being announced. It is still rather early to favour these strategies, but we are monitoring this area more intensively and expect that within one quarter or so, we can upgrade these strategies to a positive view. If this is to happen, though, the world economy and company transactions will have to live up to today’s consensus, a continued and steady recovery in both cases.

Those CTA (Commodity Trading Advisors) funds that focus mainly on long commodity positions performed best during the rough patch in October. This was because volatility has been relatively unchanged in commodities, unlike other asset classes that CTA funds use: fixed income management, equity index, equities and foreign exchange management. The managers’ good earnings in commodities did not suffice to offset the downturns in other asset classes, however. Overall, we have a positive view of CTA. Trends began to be established during the second quarter, and these have continued. If nothing unforeseen happens, CTA should have good potential ahead.

We are also positive towards Macro strategies. The technique of investing across several different asset classes provides good opportunities for future returns, we believe. Examples of recent transactions by Macro managers are buying the S&P 500 and selling Nasdaq. There is a trend towards investing in large companies again instead of small ones. We can also see that many Macro funds are still selling US dollars, but this position is showing a tendency towards becoming over-established, and there is a risk of corrections. This needs to be monitored, since a broad market shift in attitude towards the dollar would change the attitude towards many other asset classes as well.

A normalised world will bring a positive change in opportunities for Macro managers to generate returns. It is no longer merely a matter of central bank-directed stimulus. Instead, there will be additional driving forces for Macro managers to take advantage of.

On the whole, the good times for hedge funds will continue. At the main strategy level, we prefer Macro, Distressed and Fixed Income and are more neutral towards Equity L/S and Event Driven strategies, but at the sub-strategy level the picture is more varied.

Rickard Lundquist is a Portfolio Specialist at SEB Private Banking. He has 14 years of experience within the banking sector. He works within the Private Banking area, where he is responsible for hedge funds and commodities and where he works on the discretionary and advisory buy-side. Lundquist has a Masters degree in Business Administration and has consultancy experience in enhancing process steering in manufacturing prior to working in banking.

SEB is a Northern European financial group serving some 400,000 corporate customers and institutions and five million private individuals. On September 30, 2009, the Group’s total assets amounted to SEK 2,233 billion (US$ 313 billion) and its assets under management totalled SEK 1,295 billion (US$ 181 billion). The SEB Group has about 20,000 employees.


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