Struggle to stand still

July was a tough month for European long/short managers. Simone Leontis explains why. The great mantra from the alternative investment industry that hedge funds can deliver positive returns in any market conditions has been tested to the limit over the past few months. With major stock markets plunging by 25 per cent since the start of the year, many hedge funds have even struggled to stay above water. The falling markets of 2002 have not only reiterated the advantages of being able to short stocks as well as go long but highlighted the fact that hedge fund strategies can take very different investment approaches, which in turn can produce very different levels of returns. In the first six months of the year, the CSFB/Tremont Hedge Fund Index returned a small absolute return of 1.34 per cent, but this masked divergent performances by the main alternative investment strategies. While emerging markets returned 5.13 per cent and global macro 7.04 per cent to the end of June, long/short equity delivered a dismal –0.55 per cent return and convertible arbitrage –1.00 per cent. Mark Barker, director of Momentum UK, which was bought by Italian bank Unicredito Italiano for e120m in May, says July was one of the toughest months he could remember for European long/short managers. The long/short strategy is the most heavily exposed of all alternative investments to stock markets. He says: “It was very difficult to make money in July. Most delivered returns of between zero and –5 per cent or –6 per cent. Most long/short managers have been net long this year as net short is a very dangerous place to be in this environment. “The problem for managers in July was that there were no trends in the movement of stock markets and all rationality went out of the window in the week beginning July 15. “The other problem is that the bear rallies have been severe during the summer. But the markets are a lot more rational now.” He says distressed managers, who normally prosper in difficult economic conditions, have been resilient without producing impressive returns because of widening credit spreads. “The volatile stock markets this year have been difficult for most hedge fund strategies with managers having to work hard just to stand still,” adds Mr Barker. Over the past year, Swiss-based RMF, which has e7.8bn in assets under management and was bought by Man Group in May for e908m, has been reducing its exposure to equity hedge, particularly long/short, and event driven strategies while increasing its weighting to managed futures and global macro managers. Urs Spoerric, head of external investments at RMF, argues that the approach of most hedge fund strategies in 2002 has been to preserve capital “during difficult times for the investment industry, which have separated the men from the boys among alternative investment managers”. To gain returns of between zero and 12 per cent from the start of the year, investors have needed diversified hedge fund portfolios across a number of strategies, according to Mr Spoerric. The best performing strategy this year, says Mr Spoerric, has been managed futures. This strategy has delivered 15 per cent since the start of the year in RMF’s portfolios. “Managed futures funds perform well when stock markets are suffering crises, such as that of 1998, as they are short equities. They have outperformed other strategies so far this year,” says Mr Spoerric. Global macro managers have had a resurgence this year in performance, producing a return of three per cent for the RMF portfolios, because they have benefited from major events like the fall in the value of the dollar and movements in other currencies. Arbitrage strategies have found it difficult to make positive returns because event driven managers have been hit by the widening credit spreads over the past few months. “Arbitrage managers are generally flat for the year as they have been hammered by the collapses at WorldCom and Enron,” adds Mr Spoerric. Mr Spoerric agrees with Mr Barker that the long/short managers have been most heavily hit by the plunging stockmarkets, although market neutral funds have performed better. Investors who have been attracted to hedge funds in the past two years because of their potential to make money while stock markets fall in value have learned a valuable lesson in the past few months. Not all strategies are the same and volatility can make it hard for even the best stock-picking long/short managers to deliver positive returns.