Hedge Funds Learn to Profit from Higher Volatility

Date: Monday, June 23, 2008
Author: Laurence Fletcher, Reuters

 MONACO (Reuters)—Hedge fund returns look set to pick up this year after a poor start, as managers learn the painful lessons of recent months and feel well positioned to profit from opportunities arising in credit and equity markets.

Having cut back the leverage that caught out some funds last year and rebuilt computer-driven models hit by a vicious circle of selling last summer, funds now see opportunities amid high market volatility and a greater chance of corporate default.

Speaking at this week's GAIM International 2008 hedge fund conference, high-profile manager John Paulson said he sees a $10 trillion opportunity appearing in distressed debt and good value in higher quality mortgage debt.

Others hope to profit from forced selling of equities or better conditions for convertible arbitrage.

"If everything has been written down on the credit side, it's a great opportunity…. It's all about a lot of dumb people and a few smart ones," said Bill Browder, chief executive of Hermitage Capital Management.

During the first quarter, in which a sharp market reversal after the U.S. Federal Reserve's bailout of Bear Stearns Cos. Inc. caught out many funds, the Credit Suisse/Tremont index of hedge fund returns was down 2.01%.

While outperforming the MSCI World's 9.5% fall, this was well below what investors might expect from an absolute return-focused asset class.

However, recent data suggests funds are starting to get used to post-credit crisis market conditions.

In May the Credit Suisse/Tremont index jumped 2%, its biggest gain this year, helped by strong performances from long/short equity, emerging markets and event-driven funds, pushing the index back into positive territory year-to-date.

"We're just beginning to see a fun market for stock pickers," said Renaud Saleur, an equity long/short manager at Jabre Capital Partners, who expects to profit from a renewed wave of forced selling by investment funds seeing redemptions.

Convertible arbitrage managers, meanwhile, are spotting some of their best opportunities in years, with returns set to match those that came after credit selloffs in 2005 and 2002, thanks to ideal conditions of high volatility and wide credit spreads.

Good Opportunities

Even quantitative, or computer-driven, funds—which were hit last July and August by a vicious circle of deleveraging in an overcrowded sector—are feeling more optimistic that the quant fund space is less crowded than a year ago.

"I do think we can find good opportunities going forward in the quant space," said Robert Litterman, managing director of quantitative resources at Goldman Sachs Asset Management. "We're feeling much better than we have for a long time."

However, the biggest profits look set to come from distressed debt where Mr. Paulson, who made $3.7 billion in 2007 from shorting subprime according to Alpha magazine, sees a $10 trillion opportunity emerging in the next six to 24 months.

Hedge funds are starting to hire distressed debt experts ahead of what they see as an inevitable surge in corporate defaults as companies are hit by higher debt costs and a slowing economy.

"The fundamentals will be a lot worse than last time (after the dot-com bust of 2002). The distressed cycle will be deeper and longer and provide us with better opportunities than we've seen for a long time," said Ken Glassman, who helps run $16.9 billion at Sandell Asset Management.

"We finally have a combination of high quality businesses with highly leveraged capital structures. Last time you could argue there were a lot of technology companies that didn't need to exist."

However, managers acknowledge distressed debt has yet to fall to bargain-basement prices, although Martinsa Fadesa debt recently traded at 50 pence ($0.99) in the pound while Spanish retailer Cortefield has traded in low 60s.

In the meantime, managers are still finding the credit crisis throws up market volatility.

Mr. Paulson is making money by shorting financial stocks and buying protection against them defaulting on their debt, and is also looking to buy the more senior tranches of the mortgage debt he shorted last year.

Christophe Aurand of York Capital even sees mileage in merger arbitrage now that volatility has picked up.

"We're not yet in the full cycle of distressed and we've passed the full M&A [mergers and acquisition] cycle. But there are a lot of things providing us with opportunities.

"We're not in an environment where it's about the time value of money (in mergers and acquisition situations). We're in an environment of … very unsettled situations, which offer the opportunity to make a lot of money."

By Laurence Fletcher