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Whither hedge funds?

Richard Willsher is a freelance journalist specialising in finance.

Money has been pouring into hedge funds but performance, in general, has been disappointing. Meanwhile new trends are emerging as funds and their investors seek better returns. Richard Willsher reports

Industry sources calculate that around 8,000 hedge funds worldwide now manage in excess of $1trn (£555bn) worth of assets. This is before the leveraging effect of additional funding raised on the back of core holdings. There has been astonishing exponential growth in the sector since 1990 when HFR, Van Hedge Fund Advisors calculates that assets under management stood at less than $500m (£277m). Growth is set to continue according to LJH Hedge View, an industry newsletter published by Florida-based LJH Global Investments, which reports that by 2010 hedge fund assets could reach $4trn (£2.22trn). Big numbers by most people's reckoning but hedge funds are still a specialist niche.

Still a niche
Analysts at JP Morgan Securities have calculated that at the end of 2003 the world's equity and bond markets had a total capitalisation of around $74trn while the total assets of the world's 1,000 largest banks amounted to $52trn. Hedge funds appear to account for less than 1% of the world's financial assets. The key attraction of hedge funds is that because regulation is still in its infancy, they are able to invest in ways that mainstream fund managers are not allowed to, including being able to borrow to invest. Consequently, because they are typically smaller and more nimble entities they can quickly identify and exploit investment opportunities in the financial markets.

Having produced spectacular returns and also having had some headline-grabbing accidents in the past, the hedge fund sector has been becalmed for the last year. Various hedge fund indices have shown annualised returns of 2-3% which compares poorly not only with the main equity market indices but also with the fees that hedge funds typically charge the clients for managing their money. These are often 1% of assets under management and 20% of net annual returns.

Long only
In a move apparently to give themselves more time and more stability, some hedge funds are requiring their investors to accept longer 'lock-ins'. Morgan Stanley's Huw van Steenis and Bruce Hamiltion have identified a significant number of hedge funds that have set up 'long-only absolute return funds'. This means investors maintaining their investment in the funds for, say 12 months or more, rather than being able to liquidate their positions on a quarterly or six-monthly basis. It is important to note however that 'long only' funds are typically equity market-related funds, which is only one asset class in which hedge funds may invest. In addition long only funds have been a part of the hedge fund menu for some time.

Against the background of increased investor demand, especially from standard investment funds seeking diversification as well as higher returns, some of the bigger investment banks have begun either acquiring or taking stakes in hedge funds. Examples to date have been JP Morgan's purchase of a majority stake in Highbridge Capital Management and Lehman Brothers reportedly in talks with GLG Partners while several major private equity firms in the US have begun developing hedge fund capabilities.

The real question for investors, however, is not who owns them but have particular hedge funds the expertise to spot exceptional investment opportunities and exploit them? Classic market driven strategies have included short selling, that is selling equities as their price falls, buying them back at a lower price and profiting from the difference. Other well known strategies include investing in equities which have either fallen out of indices and have therefore been the subject of rapid selling by fund managers that has caused the stocks to become undervalued. Conversely, buying stocks about to be included in indices may produce rapid price hikes. The comparable strategies in fixed interest would be to buy bonds following a downgrade or before an upgrade. These strategies may not be open to mainstream regulated fund managers constrained by internal investment criteria.

This would seem to be a good argument against regulating hedge funds. Those in favour of regulation say that it would ensure good internal governance and prevent systemic risks of the type posed by the long-term capital management crisis in 1998. This debate continues and has been the subject of many column inches and industry and academic papers. Meanwhile JP Morgan Securities and others are asking whether the proliferation of hedge funds and the increasing volume of money they deploy is tending to neutralise the very opportunities and market anomalies they try to take advantage of. Are they having the effect of providing huge additional liquidity to markets where lack of it in the past had been a significant factor in creating investment opportunities for them?
Additionally, the history of financial markets includes many examples of early movers making excellent profits while latecomers have first missed the opportunity and then gone on to lose money as markets became saturated. The emerging market debt crash of the early 1980s, the London commercial property sector in the early 1990s, and the dotcom bubble a decade later are all cases in point. Could this be in store for the hedge fund sector?

If so, long-only funds look a good deal less appealing. Are hedge funds just providing breathing space for themselves, avoiding short term reporting and liquidity that investors in some funds have come to expect? Certainly the level of returns recently graphed by the hedge fund indices seem to endorse the old adage that financial services purveyors like to troll out when it suits them: that past performance is no indication of future returns.

Industry analysts are bullish however that there are stellar opportunities to be found in the hedge fund universe. Laurent Fransolet at JP Morgan Securities says that while long-only products are normal hedge fund fare, opportunities are abundant in less used areas of the financial markets. These include specialist fixed income managers moving into areas such as credit-based strategies where mainstream markets may be mispricing short-dated bonds which are close to the BB investment grade break point. He also highlights emerging market funds where large price movements and thin markets provide the sort of arbitrage opportunities upon which hedge fund managers traditionally thrive.

The area which is least attractive at the moment could well be fund-of-hedge funds, which is where mainstream pension funds and other asset managers are now increasingly apportioning funds under their control. Consultants at Watson Wyatt and Psolve Asset Solutions confirm this allocation trend and that their fund management clients choose a fund of funds where they can gain exposure to a variety of different investment strategies and hedge fund managers under one over all manager.

It would be a clever manager indeed that could identify a hat full of above average performing hedge funds for his fund of funds but any other selection will tend to result in a reversion to the mean which is pretty unspectacular at this time and which neutralises the principal attraction of unregulated hedge funds.

The key to success in investing in hedge funds must then be identifying those managers who are constantly innovating and can demonstrate fleetness of foot in seizing great investment opportunities. The likelihood that any one manager can consistently achieve this over time looks pretty unlikely. It must therefore be in the investor's interest to remain as free as possible to choose rising stars with great ideas and discard declining performers. Wrapping up funds for more than 12 months at a time would seem to run counter to such flexibility and to investors' best interests.

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