Choose wisely in fragmenting hedge fund industry

Date: Tuesday, August 5, 2008
Author: Laurence Fletcher, Analysis, Reuters.com

LONDON (Reuters) - Hedge funds are looking less and less like a single asset class as the credit crisis sweeps through the industry and picking the right strategy will become more important than ever in the second half.

The days when buying into almost any hedge fund strategy meant a good chance of positive returns are now long gone, with more than half of strategies showing themselves unable to make money in the first half of the year.

For example, while Man Group's (EMG.L: Quote, Profile, Research, Stock Buzz) flagship AHL managed futures strategy rose 15.1 percent in the first half, RAB Capital's (RAB.L: Quote, Profile, Research, Stock Buzz) flagship Special Situations strategy, which mainly buys small-cap oil and mining stocks, lost 23.1 percent.

"These are volatile markets. Volatility is rising and there will be winners and losers. It's so difficult to put hedge funds all into one package," David Stewart, chief executive of Odey Asset Management, told Reuters.

The performance of the hedge fund industry could hardly be more different from a year ago.

In the first half of 2007 the Credit Suisse/Tremont index was up 8.7 percent with every strategy except dedicated short bias -- often used simply as a portfolio hedge by investors -- well into positive territory.

So far in 2008, the index is up just 0.51 percent. According to HedgeFund Intelligence's indexes, hedge funds had their worst first half-year performance since 1998.

Long/short equity funds, which hold shares they think will rise and short-sell the ones they see dropping, are down, damaged by exposure in falling markets and rapid market reversals like the one after the bailout of Bear Stearns, which hit bets on further bank woes -- being short financial stocks and owning credit default swaps.

Convertible arbitrage, which looks for relative value opportunities in convertible bonds, as well as emerging markets and those looking for price discrepancies in fixed income are also still in negative territory.

In contrast, strategies that can play big themes such as the oil price, the dollar or credit spreads in both directions are thriving in these conditions.

Managed futures, which trade across global stock, bond, energy, commodities and other futures markets, are up 14.86 percent while global macro is up 9.22 percent.

DIVERGENCE

Simply betting that markets will stabilize in the second half and hedge returns across the board will improve now seems overly optimistic.

"If it's been a tough first half, it doesn't necessarily mean it will be an easier second half," said Odey's Stewart.

With volatility .VIX spiking again in July, corporate profits under pressure, emerging markets coming off the boil and even commodity and oil prices now falling, the gulf in performance between funds is set to remain.

Fund of hedge fund managers are actively reshuffling their portfolios to take advantage of the next winning strategies.

"CTAs (commodity trading advisers or managed futures) did well because of a very well affirmed trend, and macro for the same reason," said Francois Barthelemy, partner and fund manager at F&C Partners.

"I believe these are not going to work (in the second half), I'm shifting away. I believe trends are going to reverse, which is painful."

However, while strategies such as distressed debt or special situation investing may come into their own as corporate defaults rise and oversold assets reprice, the winners in this new environment may also be differentiated by size.

With the larger funds already benefiting from the lion's share of inflows as investors hunt for safety and fewer restrictions from prime brokers keen to look after their biggest clients, they look best placed to profit from opportunities offered by market volatility.

"Performance will continue to diverge in the second half," said Amin Rajan, executive of independent fund management consultancy CREATE-Research.

"Big hedge funds with capital -- and less reliance on leverage -- will be well placed. Unfortunately, that necessarily means a small minority."

(Editing by Sue Thomas)