Fund of hedge funds model sound but liquidity structure concerns remain

Date: Tuesday, March 3, 2009
Author: Hedgeweek.com

Against a background of industry debate over whether the funds of hedge funds model is flawed, Standard & Poor's Fund Services notes in its latest sector update that the sector succeeded in outperforming traditional equity investment substantially in 2008.

'We feel that the basic investment idea behind the fund of hedge funds model is sound,' says S&P Fund Services lead analyst Randal Goldsmith. 'If anything, 2008, the worst year on record for funds of hedge funds model, demonstrated very clearly the risk associated with long-only, index-driven investing.'

Goldsmith says that although most hedge funds failed to deliver positive absolute returns in 2008, drawdowns were generally lower than for mainstream funds and indices. While the average global multi-strategy fund of hedge funds lost about 18 per cent in 2008, the S&P Global 1200 was down by 40.1 per cent.

However, S&P Fund Services' sector update identified the liquidity structure of funds of hedge funds as a specific weakness that has been exposed by recent market conditions.

'About 18 per cent of funds of hedge funds have been forced to suspend or gate investor withdrawals and about ten per cent have been forced to side-pocket illiquid hedge fund holdings,' Goldsmith says.

He notes that about 41 per cent of S&P-rated funds of hedge funds have changed their dealing or redemption notice terms during the past six months, with the majority now having a notice period for investor withdrawals of about three months.

'Recent experience underlines the importance of keeping portfolio liquidity in line with the funds of hedge funds model notice period, without placing too much reliance on credit to bridge a mismatch,' he says.

S&P Fund Services identified some unexpected examples of fund managers who are optimistic about the second half of the year, including Charles Hovenden, chief investment officer of Absolute Fund Management, one of the more cautious fund of hedge funds managers over the years.

Hovenden says that 'once in a career pricing anomalies' created in securities markets in the wake of the credit crisis should see the Absolute Fund deliver its strongest ever 12-month period, beating the 15 per cent it made in 1999.

However, he agrees with the majority of managers that for these opportunities to be realised there will have to be a break in the vicious cycle of forced selling, so that investment fundamentals begin to drive asset prices again.

At GAM, David Smith is wary that poor macroeconomic and corporate data releases could give rise to renewed volatility in financial markets, but he feels that this could provide further opportunities to trading-oriented managers.