December volatility poses dilemma for hedge funds

Date: Friday, December 1, 2006
Author: Jeremy Gaunt, Reuters

ONDON (Reuters) - A surge of volatility on financial markets would normally be a gift for hedge funds, which thrive in such conditions, but the latest market disquiet may not energise as many of them as might be expected.

Managers of the popular alternative investment are just as likely to be trying to lock in the gains they have made this year as they are to be drawn into some last-minute aggressive plays that could themselves add to year-end market volatility.

"Although some hedge fund managers may be tempted to take on risk in December this is not a good time of year to do so," said Christopher Woods, senior managing director for absolute return strategies at State Street Global Advisors.

"In contrast to taking on risk, many managers will be putting their portfolios to bed for year end."

The conditions are there, however, for hedge funds to be tempted, particularly those for whom this year's returns have been disappointing and who need to boost the bottom line.

The dollar began a sharp decline a week ago that has seen it lose close to 3 percent against a basket of currencies, shattering the previous calm on foreign exchange markets.

There has also been some spill over. Equity markets shuddered as the dollar fell, with major indexes dropping 2 to 4 percent in a matter of days. But they have bounced back -- in some cases to record highs.

Volatility as measured by the VIX index <.VIX> has gone for a ride accordingly. In a little over a week it has jumped nearly 28 percent from a 12-year low then fallen back around half that.

If any of this looks like continuing, such opportunities may be hard to pass up, particularly in foreign exchange where the main volatility has been found.

"I'm sure they are all short the dollar right now," said one specialist who asked not to be named, suggesting a reversal in the U.S. currency's fortunes could cause some disruption.

One factor dictating how tempted a hedge fund might be to play markets aggressively in December is how well it has performed to date.

The Credit Suisse/Tremont Hedge Fund Index shows overall returns were 9.55 percent up to the end of October. Although not bad -- and an improvement on 2005's 7.61 percent -- this pales in comparison with simply tracking stock indexes this year.

MSCI's main world index, for example, has gained more than 16 percent year-to-date while its emerging market counterpart is up more than 24 percent.

But the overall returns figure masks different success rates among different hedge fund strategies.

The index for event-driven hedge fund investing -- into mergers and acquisitions, for example -- shows returns of 11.59 percent. By contrast, the index for those with a heavy bias to short equity positions has suffered an overall loss.

Managers of successful strategies are unlikely to be keen to do much in December that endangers their yearly gain.

"I suspect it will depend firstly on what the P&L (profits and losses) are looking like at the moment and secondly the type of hedge fund," said Martin Harrison, head of mutual funds UK at GAM, a specialist in hedge funds and funds of hedge funds.

"In the case of an equity long-short fund, if they are in double figures they may try to lock that in for a gain."

Harrison noted, however, that there was little sign at the moment of long-short equity managers within its flagship multi-strategy GAM Diversity Fund, taking risk off the table.

"We would tend not to favour managers who lock in just to save their performance fee for the year," he said.

HAPPY NEW YEAR

There is also no guarantee, meanwhile, that December is going to provide hedge funds with a special opportunity they need.

Although research by Citigroup Private Bank shows that over the past 16 years December has been the best month for hedge funds, equity markets may not play ball this year.

Philip Watson, head of the Citigroup Private Bank's investment analysis and advice group in Europe, said that 2006 equity markets did unusually well in September and October.

"As the recent downward turn suggested, equity markets could be running out of steam in the short term," he said.

But motivation would still be there as 2007 approaches. "In December you are trying to reach your goals, in January you are trying to start off well."

State Street's Woods also reckons that December could be disappointing.

"Liquidity will be low and in some markets retail investors can dominate in the quiet period between Christmas and New Year leading to perverse price moves," he said.

But the new year beckoned.

"My expectation is that we will see volatility pick up in January as new positions are opened up," he said.