Hedge funds are back. After a dismal 2008 that saw record losses and record withdrawals and negative publicity connected with the role of hedge funds in creating the recession, investors are returning to the sector, prompted by signs that hedge funds made money, even as markets plunged this year.

Putting it into perspective, at January 1 2008 there was $9.7trn of hedge funds assets invested, at the end of 2008 it was $3trn, a massive loss in capital.

This year, hedge funds gained 2.41 per cent in March, according to the Barclay Hedge Fund Index compiled by BarclayHedge. The index is now up 0.82 per cent in 2009. “After an eight per cent sell-off in early March, the S&P 500 Index bounced back to gain 17 per cent from 9 March to 31 March, its largest three-week rally since 1987,” says Sol Waksman, founder and president of BarclayHedge. Overall, 15 of Barclay's 18 hedge fund indices gained ground in March. Hedge funds took modest advantage of March’s upswings in the global equity and credit markets, according to Morningstar’s hedge fund performance summary for the first quarter of 2009.

Highbridge Capital Management, once the world's biggest hedge fund, was a big winner, with $1bn of net inflows this year, including $225m from majority owner JPMorgan. It ended the quarter with $20bn under management.

De-risking and short selling

John Anderson, managing director in the JP Morgan fund of hedge fund group, puts the losses of last year into perspective. “Although it was pretty bad, when you compare it to equities for instance, they did protect some capital. If you look at hedge funds over a one, three, five or ten year basis, hedge funds have still outperformed equities on an annualised basis.

“Most of the poor performance for hedge funds came in a two month period: September and October, driven by a flight to quality. After the Lehman Brothers failure, everybody was looking to de-risk their portfolio, which included hedge funds, which use leverage.”

Indeed, hedge funds represented one of the fastest growing segments in asset management, with industry assets under management expanding at more than 20% per year between 2000 and mid-2008.

Although for Ewen Cameron Watt, managing director at BlackRock’s Multi- Asset Portfolio Strategies group, the losses should not have been inevitable.

“A hedge fund in theory is a fund and method of investing with a focus on making absolute return, rather than a return driven by stock market return.”

With an equity fund “the investor makes a choice between the assets and it is the asset class that drives the risk not the manager,” says Watt, “with a hedge fund it is exactly the opposite. The hedge fund manger is managing the risk rather than allowing the markets to manage the risk of the fund. Many hedge funds became very directional, linked to the direction of the stock market for returns, and became that with a great deal of leverage.”

In the bigger picture of the economy, government intervention also had an impact. Anderson explains: “Last year in the sell off, many governments banned short selling. That had an impact. It also had unintended consequences. They tried to stop the sell off in financials, after that financials went down substantially more. Short sellers provide liquidity in the market and they [governments] took that liquidity out, at a time when you could argue, you needed liquidity.”

But what about the view that hedge funds contributed, even helped to create the recession? “In terms of them bringing down the financial system; that is well overblown,” says Anderson. “There was leverage throughout the financial system not just with hedge funds. Banks and individuals were over extended and when asset values started to decrease, many had to deliver, including some hedge funds.”

Markets and approaches

So which approaches are seeing a bounce? The Barclay Emerging Markets Index jumped 4.74 per cent, Equity Long Bias gained 3.51 per cent, Technology was up 3.20 per cent, Pacific Rim Equities gained 2.65 per cent, Healthcare and Biotechnology rose 2.36 per cent, and Convertible Arbitrage was up 2.25 per cent.

“Emerging market funds did exceptionally well in March, driven by double-digit returns in the equity markets in Brazil, Russia, India and China,” says Waksman. “With the sudden upturn in equity markets, Equity Long Bias had its strongest one-month performance since gaining 4.72 per cent in January of 2006.”

Furthermore following a gain of over 1% in the first quarter 2009, the HFRI Emerging Markets (Total) Index advanced over 7.5% in April. This was the best performance month since December of 2000, according to data from Hedge Fund Research.

For the quarter asset gains due to performance added $5.1bn to emerging markets hedge funds assets under management, nearly offsetting investor withdrawals of $6.4bn. Although the strong performance by emerging markets hedge funds year to date, 2009 follows a decline of 37.2% in 2008, the worst calendar year performance for emerging markets since HFR began tracking hedge fund data in 1990.

“Investors exhibited extreme risk aversion at the end of 2008, withdrawing record amounts of capital. While redemptions continued in the first quarter at a slightly lower level, risk aversion began to recede into the end of the quarter and has continued to fall,” says Kenneth Heinz, president of Hedge Fund Research.

On other markets, Anderson adds: “If you look at some of the large dislocations, some have come back: convertible bonds sold off dramatically and offered some good opportunities, and you have seen that from the solid performance over the last few months. Some of the credit sectors have sold off dramatically. And the government is stepping in to find solutions, which allows investors, including hedge funds, to use and get leverage at attractive terms. So I would say credit, broadly, is probably the most attractive, that is asset backed securities, some high yield, strategies like that.”

Watt says: “The strategy that hedge funds have been taking exposure to this year has been debt related strategies, those are the ones where the assets are sold off. The most popular strategy overall is long-short equity. A recent survey said that endowments, which are in hedge funds are in long-short.”

Reports in the financial press suggest that managers of some of the world's leading hedge funds are reaping a benefit from the financial crisis in the form of less competition from the once-mighty proprietary trading desks of investment banks. “A lot of proprietary desks exited the business, freeing up capital, but also many hedge funds went out of business. So competition is going to be less for those that survive this. It will be a good thing. Less competition and a wider spread, which can lead to opportunities,” says Anderson.

Funds of hedge funds
Following the trend of hedge funds, the funds of hedge funds industry shrank by almost 30 per cent last year, with most of the losses coming in the latter part of the year as volatile markets, poor returns and the impact of the Bernie Madoff scandal took their toll. More than $1,000bn in assets was held in funds of hedge funds in June last year but, by the end of the year, about $300bn had flowed out of the industry. All indicators though, are that fund of hedge funds are bouncing back.

BlackRock is one group plugging into this, it launched a ‘Fund of Alternatives’ pooled fund for pension schemes, charities and other institutional investors. The Fund invests in a range of alternative investments, aiming to generate positive absolute returns with limited correlation to traditional equity and bond markets.

The Fund leverages BlackRock’s market-leading position in alternative investments and its expertise in asset allocation and managing the risks associated with investing in these instruments.

Alternative assets – a broad term used to define assets which exclude traditional equities, bonds and cash – are increasingly popular as a way for charities to diversify their portfolios.

Ewen Cameron Watt, managing director at BlackRock’s Multi-Asset Portfolio Strategies group, says: “Institutional investors should consider an alternatives component for their portfolio. Alternatives offer diversification and help to enhance long-term returns and to reduce volatility.We estimate that funds should allocate around 10-15% of total assets, or 25% of nonbond assets, to alternatives

.“But managing an alternatives portfolio needs time and attention particularly in terms of monitoring risk and asset allocation. For investors without the necessary resources to do this, a pooled fund is ideal.”

The fund invests across the full spectrum of alternatives, including hedge funds, funds of hedge funds, commodities, property and infrastructure, and will have the flexibility to invest in funds run by external managers as well as directly into BlackRock’s own alternatives funds.

Trustees and hedge funds

When it come to charities approaching hedge funds, what is their view? Anderson says: “When you mention hedge funds, the initial reaction is often one of being scared. It is getting over the understanding and hurdle that not all hedge funds are big, huge risk takers, in fact hedge funds can be risk reducers.”

Are trustees to blame here? “A number of them are not investment experts, but they are not supposed to be. It is the role of consultants, even investment managers, to do that education,” says Anderson.

“The trustees act requires them to consider liquidity diversification. And an asset liability timing mismatch comes up in relation to hedge funds and other alternative assets,” says Cameron Watt. “It also has a bearing on the type of strategies used.”

Anderson has experienced charities investing everything from a couple of per cent to 25 per cent. “A lot depends on the comfort level, their spending policies, do they have the wherewithal to stand some volatility or not? If you are in a well funded position, I see a higher allocation of hedge funds because they have delivered more stable returns.”

Increased regulation

One potential set-back in the positive hedge funds story, is the threat of increased regulation of hedge funds by the EU. The belief is that the EU will drive some out of business and lead to a shrinkage of the industry, a view expressed by Peter Clarke the chief executive of Man Group, the UK’s biggest listed hedge fund manager. Clarke said smaller managers who did not have the resources to cope with additional demands from watchdogs would be hit hardest. He said Man, in contrast, was well-placed to cope with additional controls.

“Increased regulation is coming,” says Anderson. “Depending on how it is structured it may or may not be an issue. Regulation, if it is not too restrictive, and looking to get better insight and controls, then we think that is a positive.”

Hedge fund future developments

The sums involved in hedge funds are still substantial. Hedge fund assets will bottom out at roughly $1trn in 2009, after which capital appreciation and $800bn in net inflows over the next four years will push global levels to $2.6trn by 2013, according to a study of institutional investors, investment consultants and hedge funds by The Bank of New York Mellon BK and Casey, Quirk & Associates.

The study, entitled The Hedge Fund of Tomorrow: Building an Enduring Firm, found that institutions remain firmly committed to hedge fund investing. Institutional investors comprised less than 20% of hedge fund redemptions in 2008-2009, and North American pension plans will represent the single largest source of new capital between 2010 and 2013, followed by British and Northern European institutions.

Global high net worth investors could account for as much as 60% of new net flows between 2010 and 2013, although their return to hedge fund strategies will rely on capital market conditions and hedge fund performance.

Funds of hedge funds will solidify their role as the primary hedge fund distribution channel, capturing almost 60% of net inflows between 2010 and 2013 by continuing to offer services most investors will find difficult to replicate on their own, such as manager-sourcing and ongoing due diligence. According to the report, the hedge fund industry is facing a "transformational crisis" and must address key shortcomings in its business and operating models. As a result, hedge funds will rely more on third parties for a growing range of administrative support.

Fund administrators will play a greater role in hedge funds’ operations, which will require stronger integration of hedge fund servicing activity with traditional custody and cash platforms.

“The events of 2008 have changed the old dynamic. Investor and regulatory demands for new levels of transparency mean the legacy operating model no longer works,” says Brian Ruane, executive vice president of Alternative Investment Services at The Bank of New York Mellon.

“Hedge funds increasingly will turn to independent third parties for middle-and back-office functions such as portfolio accounting and reconciliation, custody of non-collateral assets, pricing and valuation, cash management, and counter-party risk-mitigation. Allowing third parties to play a bigger role in their business will be a sign the hedge fund industry is maturing.”

“Enduring hedge fund management firms will more closely align their business models with investor needs for transparency and liquidity. This means new fee models and longer-term incentive structures,” says Kevin Quirk, a partner with Casey Quirk.

“By striking betterdesigned balances, they will come to define the central value proposition of active asset management.”

While the single-strategy boutique remains a viable model, better-designed and more durable investment management businesses will capture a majority of new hedge fund assets.

Four models likely to thrive in the coming years include:

• Single-Strategy Boutique: ‘Classic’ hedge fund, dominated by a typical direct investment capability using hedge fund techniques
• Multi-Capability Platform: Common brand, distribution and business infrastructure support multiple distinct alternative investment capabilities
• Merchant Bank Alternative Manager: Diversified financial intermediation business with core capabilities in investment management
• Converged Traditional-Alternative Manager: Investment firm that has successfully integrated alternative and traditional long-only capabilities

The BNY report concludes: “We remain optimistic on hedge funds’ future, perhaps because of, and not in spite of, the crisis and turmoil. The industry’s current trials will, no doubt, result in a dramatic reconfiguration of the hedge fund and fund of hedge fund landscape, a wrenching process which will hurt competent managers and damage otherwise good businesses.

“However, this process also represents a unique opportunity for this industry to finally mature, shedding many practices, standards and anachronisms that ultimately hold back hedge funds and their managers. This includes an operating model that no longer works, poor transparency practices, an anti-regulation mindset, outdated terms, and poorly aligned fees and compensation schemes. In sum, a business model designed to maximize short-term volatility.”

HEDGE FUND STRATEGIES

Aggressive Growth: Invests in equities expected to experience acceleration in growth of earnings per share. Generally high P/E ratios, low or no dividends; often smaller and micro cap stocks which are expected to experience rapid growth.

Distressed Securities: Buys equity, debt, or trade claims at deep discounts of companies in or facing bankruptcy or reorganization. Profits because the market lacks an understanding of the true value of the deeply discounted securities and because the majority of institutional investors cannot own below investment grade securities.

Emerging Markets: Invests in equity or debt of emerging (less mature) markets which tend to have higher inflation and volatile growth.

Fund of Funds: Mixes and matches hedge funds and other pooled investment vehicles. This blending of different strategies and asset classes aims to provide a more stable long-term investment return than any of the individual funds.

Income: Invests with primary focus on yield or current income rather than solely on capital gains.

Macro: Aims to profit from changes in global economies, typically brought about by shifts in government policy which impact interest rates, in turn affecting currency, stock, and bond markets.

Market Neutral: Arbitrage: Attempts to hedge out most market risk by taking offsetting positions, often in different securities of the same issuer. For example, can be long convertible bonds and short the underlying issuers equity.

Market Neutral: Securities Hedging: Invests equally in long and short equity portfolios generally in the same sectors of the market. Market risk is greatly reduced, but effective stock analysis and stock picking is essential to obtaining meaningful results. Leverage may be used to enhance returns.

Market Timing: Allocates assets among different asset classes depending on the manager’s view of the economic or market outlook. Portfolio emphasis may swing widely between asset classes.

Opportunistic: Investment theme changes from strategy to strategy as opportunities arise to profit from events such as IPOs, sudden price changes often caused by an interim earnings disappointment, hostile bids, and other event-driven opportunities.

Multi Strategy: Investment approach is diversified by employing various strategies simultaneously to realize shortand long-term gains. Other strategies may include systems trading such as trend following and various diversified technical strategies. This style of investing allows the manager to overweight or underweight different strategies to best capitalize on current investment opportunities.

Short Selling: Sells securities short in anticipation of being able to rebuy them at a future date at a lower price due to the manager’s assessment of the overvaluation of the securities, or the market, or in anticipation of earnings disappointments often due to accounting irregularities, new competition and change of management.

Special Situations: Invests in event-driven situations such as mergers, hostile takeovers, reorganizations, or leveraged buy outs. May involve simultaneous purchase of stock in companies being acquired, and the sale of stock in its acquirer, hoping to profit from the spread between the current market price and the ultimate purchase price of the company.

Value: Invests in securities perceived to be selling at deep discounts to their intrinsic or potential worth. Such securities may be out of favour or underfollowed by analysts.

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