Are hedge funds to blame for the financial crisis?

Let us focus on some of the key issues, which have been debated over the last fortnight and indeed throughout the whole of 2008. Firstly the systematic shorting of financials and the resultant short selling restrictions, and secondly the performance of hedge funds this year and whether they are meeting investor expectations. The focus of the world has been on the viability and solvency of the major banks of the world. Over the last few weeks systematic shorting and effective ‘assaults’ on the stock of a number of firms, primarily financial stocks, has instigated regulators across the world to implement temporary restrictions on short selling of stocks. Investors typically look at both technical and fundamental factors when developing an investment thesis. Many investors believed that there were weaknesses in several financial companies due to overvalued assets, weak management and a deteriorating credit market. They used this opportunity to take negative views on these stocks - some hedge funds certainly held short positions but many other traditional investors were selling their positions based on their analysis. Following the short sale ban several of these companies continued to fall in value – were short sellers really to blame or was the market correctly valuing the financial company’s worth? Where hedge funds were implicated was when relatively safe names came under assault from systematic shorting and rumour-mongering and the public was left with a sour taste. Regulators had no option but to bring in restrictions to temper the shorting activities of market participants – made easier as precedent had been set earlier in the year when such restrictions had been initially applied. As with any investment, one needs to consider risk and return targets as well as correlation with the rest of a portfolio. One could argue that many fundamental managers – long/short and event driven have performed less well than anticipated in times of crisis. The average long short manager is down in the order of 10 per cent. However within the sector a select number of managers have performed very well. One sector of hedge funds, which historically delivers better performance in times of crisis and shows lower correlation to traditional asset classes is tactical trading: macro and commodity trading advisors who up in the region of 7 per cent plus this year. This group of managers can allocate across the four broad asset classes - equity, fixed income, commodities and currency. Most positions are taken based on fundamental economic views or can be model driven. These managers outperformed all other asset classes in 2001 and 1998 and should be a component of any hedge fund portfolio. So what do we do now? Overall hedge fund performance has not been positive in 2008 as managers struggle in wildly gyrating markets. Regulatory concerns have stressed some strategies to the point where if the temporary measures extend beyond the short term then they could become obsolete e.g. convertible arbitrage, statistical arbitrage, dedicated short sellers and many long short strategies. Hedge fund construction is key in this environment and one way we can look forward is to adjust our hedge fund sector allocations e.g. we can over-weight tactical trading and event driven strategies in a fund of hedge fund portfolio whilst cutting back the relative value and equity long/short strategies. In doing this we can switch to strategies that should offer an attractive return profile in the medium term.