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Equity Hedge Funds Plummet in January

Date: Thursday, February 21, 2008
Author: Maggie Shea, Black Enterprise

Equity-focused hedge funds had a bitter start to 2008, with most of the major hedge fund indexes down in line with the major equity market benchmarks.

Long/short equity funds tracked by Dow Jones Hedge Fund Indexes fell 6.12% last month, reflecting the erratic market response to the subprime turmoil. The loss was a significant turnaround for equity long/short funds, which gained 1.64% in December despite the sinking performance of broad equity and bond markets. Additionally, the Hennessee Hedge Fund Index's Long/Short Equity sub-index slumped 2.79% in January. The Greenwich Alternative Investments' long/short equity group lost 3.8%; long/short equity accounts for 38.5% of the overall Greenwich index. Hedge Fund Research Inc.'s equity hedge index, which includes long/short funds, returned negative 4.1% in January. And long/short equity funds tracked by the Credit/Suisse Tremont Hedge Fund Index lost 4.05%.

Losses were much less pronounced for the broad hedge fund indexes in January. The Hennessee Hedge Fund Index tumbled 2.45% last month, the Greenwich Global Hedge Fund Index fell 2.4%, and HFR's Fund Weighted Composite Index was down 1.8%.

The Standard & Poor's 500 stock index fell 6.1% in January and the Nasdaq Composite Index fell 9.9%. The MSCI World Equity Index slumped 9.5% in the first three weeks of January, finishing the month down 7.7%, according to figures from Credit Suisse.

Philippe Schenk, a director at Credit Suisse, said he thinks long/ short managers' performance predictably reflected the current market situation. "Since they have typically more long exposure than short, it's not exactly surprising that those strategies performed less well."

Further, he said long/short managers, though predominantly long, do have some short exposure, "which helps them in market corrections." Indeed, with the exception of the Dow Jones indexes, long/short funds were down less than the broad equity indexes in January.

Additionally, investing in other strategies can help mitigate the losses of a particular strategy during a given month, Mr. Schenk said. "That's why we encourage a diversified portfolio." Reflecting that sentiment, the broad CS/Tremont hedge fund index returned negative 1.48% last month, less than half the loss of that index's long/short equity component.

Ferenc Sanderson, research analyst at Lipper Inc., HedgeWorld's parent company, said long/short equity hedge funds' losses can be attributed in part to the fact that financials and the long side of the market were hit especially hard last month. "When markets are down, don't forget that the equity index tends to be highly correlated," he noted. According to preliminary Lipper research on long/short equity funds' correlation to broad equity indexes, a lot of hedge funds recently piled into large-cap stocks, which Mr. Sanderson said were "hammered" in January.

CS/Tremont long/short equity funds have become increasingly correlated to international large caps, according to Lipper research. "A lot of people piled into international large caps because they outperformed the U.S. markets since 2000," Mr. Sanderson said. "There are few - if any - managers doing small-cap international in the hedge fund and long-only space."

In past years, January has started well because with new money coming into funds, managers have ramped up their exposure and leverage. This year, however, the amplified leverage in turn increased the chance that managers would be harder hit when the market went south, Mr. Sanderson said. And since managers likely reduced their leverage and exposure amid the mid-January market downturn, few benefited from the rebound after the Federal Reserve cut interest rates by 125 basis points over just eight days.

Mr. Schenk said it's difficult to analyze long/short equity performance during this recent stretch, which he called one of the worst equity markets in years, particularly since "the last four years had great returns," he said.

Mr. Sanderson said January was the third-worst month since 1994 for long/short equity funds in the CS/Tremont index. In April 2000, they lost 7.46% amid the Nasdaq technology meltdown. And in August 1998, they fell 11.43% following Russia's bond default. For long/ short equity funds tracked by the Dow Jones Hedge Fund Indexes, their January loss exceeded any ever recorded since Dow Jones began tracking long/short equity funds in October 2004. Their second- worst performance was in May 2006, when they posted a negative 3.53% return. The worst-ever performance by equity long/short funds on the Hennessee Hedge Fund Indexes came in August 1998 when those funds lost 8.14%.

Is Bigger Better?

Institutional investors, such as pension plan sponsors, often invest in hedge funds through funds of funds. Several $1 billion- plus, equity-focused hedge funds fell between 3% and 8% in January, with some funds down in the double digits, according to performance reports obtained by HedgeWorld. Among them, the 788 China Fund lost 39.78% due to the severity of the mid-month correction on the Hang Seng China Enterprise Index and the leverage the fund used.

Past research from Credit Suisse has not found any statistical support for the argument that funds with more assets under management perform worse than funds with fewer assets under management, according to Mr. Schenk. "People believe in emerging managers - they might have good performance early on and then go out of business because they're young and inexperienced. A hedge fund gets large typically because it achieved strong returns over time."

Furthermore, Mr. Schenk said CS/Tremont's job is not to follow trends; rather "we're in the business of providing fair measurement of a certain universe. There are some arguably troubled auto companies in the S&Ps but they are in there because S&P wants to give the best representation," he said.

However, management fees can become a concern during a month like January when investors could have bought an index fund and for a fraction of the cost of a hedge fund and achieved similar returns. "When the equity market struggles it doesn't matter if investors own those assets directly, through an asset manager, a fund of funds, or a hedge fund, they are all likely to be impacted. The only thing more difficult than explaining bad performance is explaining bad performance coupled with high fees," said Diane Garnick, investment strategist at Invesco Institutional (N.A.) Inc., in an email.

"I think that's a legitimate gripe," Mr. Sanderson said. "For most funds of funds, long/short equity is a pretty big component." HFRI's Fund of Funds Composite Index slumped 2.57% in January. Funds of funds tracked by Edhec Alternative Indexes lost 2.85.

Ms. Garnick said institutional investors wanting exposure to equities need to find asset managers who focus on risk control and have large, robust research teams. "This is exactly the type of environment where risk controlled, sometimes referred to as enhanced,' equity management makes sense," she wrote.

But Mr. Schenk said institutional investors should understand the amount of risk they are willing to take over time with a certain strategy. "It is always an evaluation of the risk-return profile they feel most comfortable with," he said. "They can see how volatility has done with certain sectors over time and overlap it with the equity index - it's still lower than the equity index."