Hedge Funds Hit by Wrong Kind of Volatility

Date: Thursday, June 24, 2010
Author: Reuters

The turbulent financial markets that have characterized the first half of this year have been no friend to hedge funds, producing what could be called the wrong kind of volatility�more like a trampoline than a slide.

Hedge funds, like others, have also suffered from a particularly brutal May and an initial failure to see the euro zone sovereign debt crisis coming. Indexes that track the performance of hedge funds show them at best achieving cash-like returns since January.

The Credit Suisse/Tremont benchmark, for example, gained just 1.48 percent by the end of May, while the HFRX Global Hedge Fund Index was off 0.34 percent by mid-June. Given the popular reputation that hedge funds have as swashbuckling money machines�not to mention the hefty fees they charge for that reputation�these are not the kind of returns that many investors might have hoped for.

And this is particularly the case given the volatility of markets, a backdrop which flexible, aggressive investors should be better equipped to handle than vanilla funds.

The problem for hedge fund managers is that 2010, particularly the month of May, has delivered the type of volatility where risky assets are one day powering ahead only to reverse sharply the next, the so-called risk-on, risk-off effect which can whipsaw investors.

This has combined with high correlations between assets�the dollar falling, for example, every time stocks rise�to create some of the hardest markets to maneuver.

"The correlation between investments has been higher than expected," said William De Vijlder, chief investment officer of BNP Paribas Investment Partners. "You have higher volatility�which is good�but higher correlation. So natural hedges are hard to put in place."

Buds of May

This was the case in May when all but one of the investment styles tracked by Credit Suisse/Tremont lost most if not all of what they had gained in the previous four months. Its emerging market index, for example, lost 4.28 percent in May, leaving a year-to-date loss of 0.78 percent.

While volatility can throw up opportunities for hedge funds, they tend to dislike extreme volatility and periods when markets are not moving on fundamentals.

The currency carry trade, for example, based on interest rate differentials, has been more sensitive this year to stock market movements than economic data and interest rate expectations.

Some computer-driven trend-following hedge funds can profit from a long-term bull or bear market but tend to lose money during sharp reversals in markets. That can be seen in the results for May, when the only hedge fund investment style listed by Credit Suisse/Tremont that gained was the one focused on shorting stocks.

MSCI's all-country world stock index lost 9.8 percent, powering the short bias index up 5.8 percent. Yet short selling has been the worst performing style this year, losing 7.8 percent even after May's good gain.

One reason is that on average equity long-short hedge funds are almost always net long�meaning they gain when stocks rise�and were so in a big way at the beginning of the year.

"The average hedge fund went into this year net long. That's been the biggest problem. They got caught by this [year's] fall," said Will Bartleet, fund manager with HSBC Global Investment Management's absolute return team.

Many hedge funds also failed to see the sovereign debt crisis coming, or at least to act on it.

"Positioning was all wrong," Mr. Bartleet said, adding that there was a degree of complacency at work.

More to Come

The silver lining for hedge funds is that their performance has been better than that of many equity mutual funds year to date. MSCI's main stocks index, for example, is still down 4.5 percent for the year, despite a 10 day rally this month.

End-May comparisons were minus 7.4 percent for stocks, plus 1.5 for hedge funds.

In that sense, hedge funds in general have met at least one investor expectation, to protect clients' money, albeit without much dynamism.

The client base has also been changing. Institutional investors such as pension funds, rather than wealthy individuals, are now dominant, so their longer-term investment horizons are likely to make them more tolerant of shorter-term losses, such as those suffered in May.

Which may be just as well. Executives meeting in Monaco at the annual GAIM conference last week forecast May's spike in market volatility could continue.

"[Hedge funds] can't deliver excellent returns in every market condition, there's no such thing. There are opportunities that come and go for certain styles," said Leda Braga, president of BlueCrest Capital Management.

Capital preservation was said to be the main goal for the rest of this year at least.