Hedge funds managers set to re-position

By Michael Coote

Friday 25th June 2004

Hedge funds have been investors' favoured sons since international equities packed up in a big way back in 2000. In a three-year period over which most equities markets knew only the way down, many hedge funds produced positive returns.

Based on "absolute return" principles, hedge funds should make money or at least not lose it whether markets go up or down, given that they use strategies designed to exploit price falls as well as rises. This approach can be distinguished from "relative return," which is measured against some market benchmark such as, say, the S&P 500 for US equities.

A relative return fund manager can take pride in losing 15% of his client's money if the benchmark he trades against lost 20%. Such a manager has outperformed the market by 5%. But a hedge fund manager can take no such satisfaction, as his absolute return objective requires that he has failed to meet its standard if he loses any client money.

The absolute return objective is not infallibly obtained. Hedge funds have hit a rough patch recently because they were wrongfooted over some unexpected market shifts. General consensus in the markets had it that a low-inflation, jobless recovery was under way in the US and that interest rates there would remain at compensatory depressed levels for an extended future period. This common view, shared by most market participants including many hedge fund managers, was systematically demolished from the end of the 2004 first calendar quarter.

Sometimes a key market turning point can be identified to the day. The first shock dated back to March 4, when US employment data came out much stronger than anticipated. Continued higher US employment statistics since then have led the US Federal Reserve to signal with increasing amplitude that the days of super-low interest rates will soon be over. The higher-risk appetite of investors that had built up over a period in which cash returns were risible collapsed in a chain event sequence, throwing markets into turmoil and taking hedge funds with them.

The big stockmarket movers of 2003-04 the small- and mid-cap stocks and higher beta technology stocks crashed. Heavy falls occurred in US and European stockmarkets. Japan's stockmarket was trashed, having risen strongly on high optimism of economic recovery, and China's took a big hit as well as hot money bailed out. There was much less sign of panic in the bond markets, where investors generally assumed modest and well-signalled interest rate rises were on the way but, oddly, corporate bond spreads did not blow out as expected.

The US dollar, in long-term downtrend, jumped against other currencies such as the yen and euro. Commodities went haywire, with oil soaring, albeit for geopolitical reasons rather than US interest rate-related considerations, but news from China that it would deliberately slow down economic growth imploded on base metal and other commodity prices.

The party is over for higher -risk-appetite investors as central banking authorities around the world converge on pre-emptive strategies against inflation and above-trend GDP growth. The final straw was the word from the Fed. Flowthrough of these surprise changes has had a systemic effect on investment markets and hedge fund strategies as investors have scrambled to realign their newly emerging "macro-picture" of economic trends with what can be expected in response from investment markets.

Equity hedge strategies took a knock if they were heavily biased to the long side of the market, especially if in the "capitalisation imbalance" situation where they were long on small- and mid-cap stocks while short on large-cap stocks. Loss of risk appetite and flight to safety hit their positions on either side. Arbitrage strategies in the bond markets were pinged as credit spreads widened, although distressed debt held up due to shortness of supply. Macroeconomic and trend trading approaches had returns dented by being too long on bonds, while systematic non-trend trading felt the impact of increasing correlation in the behaviour of asset classes.

Many hedge fund managers are in the position of a relative return fund manager insofar as they have not done as badly as indices for the markets they are in. But whereas the relative return manager can call such work well done, the absolute return manager can only judge it not good enough.

The challenge for hedge funds now is to reposition for a more risk-averse market, albeit one in which certain impacts of the March-to-June meltdown could well reverse position again. The US dollar should keep weakening overall. China is still supporting commodity prices. Interest rate panic is likely to subside and more normal cash rates will provide a business-as-usual benchmark for risk. A potential problem will include the possibility of a bigger bear market in bonds than counted upon.

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