Don’t believe the hype

There is hope for the struggling hedge fund market, but investors’ expectations must remain realistic. All things considered, 2002 should have been the year for hedge funds to shine. After several years banging at the doors of widescale acceptance by a broader universe of investors, the current bear market should have provided the opportunity for the hedge fund community to unequivocally prove its merits. Unfortunately, as is so often the case with things that are over-hyped, the reality has often not quite lived up to expectation. Granted, some hedge funds and fund of hedge funds have indeed delivered the goods. Yet many, far from providing the double-digit returns with low volatility that investors had been led to expect, have struggled to generate any positive returns. While global equity markets, as measured by the MSCI World Index, are down approximately 20 per cent so far in 2002, the average hedge fund, as measured by the CSFB Tremont Hedge Fund Index, is only up by 0.9 per cent. This in itself does not mitigate the claims of hedge funds to generate positive returns irrespective of what wider markets are doing. But it does call into question where, and how, investors should be allocating assets to hedge funds. Looking at this dispassionately, several areas of the hedge fund market stand out as worthy of comment:

• What has worked in the past won’t necessarily work going forward. A good example is the convertible bond market. As a result of the dramatic decline in equity markets, the conversion premiums on convertible bonds have expanded. Credit sensitive and ‘busted’ convertibles now dominate the universe. This has, in effect, reduced the investment opportunity set for managers who focus on capturing the volatility component of convertible bonds. Conversely, the opportunity set has expanded for convertible managers who can evaluate and effectively manage corporate credit risk. The changing characteristics of the convertible universe will have implications for the performance of convertible arbitrage managers. Future returns from these managers may be more volatile as a result of the increased exposure to corporate credit risk.
• Hedge fund strategies are cyclical. A case in point is event-driven strategies. In many respects, the late 1990s were the salad days for merger arbitrage managers; however, merger/acquisition activity remains slow with the exception of an occasional strategic acquisition. The current environment has many firms focusing on survival rather than aggressive growth and acquisition plans. Conversely, the supply of distressed debt is at record levels. This creates inefficiencies and provides event- driven managers focusing on distressed debt with a robust universe of investments.
• Views of what happened in the past may be tainting people’s strategy allocation decisions. Fixed income related hedge fund strategies continue to offer attractive investment opportunities, with the credit spreads in many markets remaining wide. The potential of tightening credit spreads may add an additional boost to performance. That said, however, this sector of the hedge fund market is attracting less money than many other sectors. Many hedge fund investors continue to be circumspect regarding fixed income strategies due to problems that occurred in 1998, following the decline of Long Term Capital Management. Recent problems with a specific mortgaged-backed manager only exacerbated these concerns. Investors appear not to recognise that many fixed income arbitrage managers have improved their risk control processes in response to 1998, making these problems much less likely to happen in the future.
• Many hedge fund strategies earn at least a portion of their return from the interest earned on cash proceeds from short sales. Consequently, the current low level of short-term interest rates will have a negative impact on the performance of these managers relative to historical averages. Overall, the hedge fund market appears to be experiencing an increase in the number of hedge funds suffering serious losses. For example, during the third quarter, a fixed income arbitrage hedge fund lost more than 50 per cent of its capital. A similar situation occurred in the first quarter when a convertible arbitrage hedge fund also got into difficulty. What these events highlight is that a properly diversified portfolio of well-researched hedge funds, possibly taking the form of a fund of hedge funds, is essential to mitigate the idiosyncratic risk associated with individual hedge funds. Overall, the current environment for hedge funds does remain promising. That said, in-depth research and realistic expectations remain key for investors considering going into this area. Derek Doupe is director of alternative investments at Frank Russell Company