Hedge funds bank on a second-half jolt

Date: Monday, July 12, 2010
Author: Emily Chasan, Reuters

Most hedge funds managed to come through the market tumult of the first half with flat to slightly lower returns, but that kind of ho-hum performance may not satisfy wealthy investors going forward.

For the year to date, the average hedge fund lost 1.45 percent, according to data released by Hennessee Group LLC on Thursday. But compared with the 7.6 percent decline in the Standard & Poor's 500 index, the lackluster performance of the $1.6 trillion hedge fund industry doesn't seem so shabby.

Still, wealthy investors, pension funds and university endowments have come to expect hedge fund managers to make money in both good and bad markets, so simply posting smaller losses than a benchmark index may not cut it.

And that means in the second half, fund managers will be under pressure to end the year firmly in the black. Many are still trying to regain their investors' confidence after a brutal 2008 that led to many fund liquidations.

Even star managers like John Paulson, whose investors celebrated eye-popping returns in 2007 and 2008, may be feeling the heat. This year, Paulson's flagship Paulson Advantage fund is down nearly 9 percent.

"A lot of funds rebounded last year from 2008. But if an investor is looking at them over a three-year-period and they are flat this year, they're not making money," said Jayesh Punater, founder of Gravitas Technology, which provides financial services to hedge funds.

The fear for many managers is that if they can't turn things around in the second half, investor redemption requests could surge in December and reverse the trend of new money coming into the industry.

Investors put $24 billion of cash into hedge funds in the first five months of 2010, about the same amount they added in the last four months of 2009, according to data from TrimTabs.

Hedge fund managers had to navigate around a lot of obstacles and unforeseen events in the first half. Concerns about European sovereign debt, the impact of financial reform on bank earnings, the potential for a double-dip recession, and the stock market's "flash crash" on May 6 all played havoc with various investing strategies. The first half was a particularly rough period for funds focused on pro-growth and currency strategies.

"The noise quotient in the market has been very high this year, and it is hard to make money when there is that amount of underlying volatility," said Jason Bonanca, head of strategy and research for hedge fund MKP Capital Management in New York.

FLAT IS THE NEW UP (AGAIN)

Ultimately, managers, who are often paid a 2 percent management fee and take 20 percent of annual profits, will have to justify those high fees with returns to their investors, who might have done better with a bank savings account in the first half.

"People who are flat are not going to be happy. But given all the headwinds that you've seen this year, what's important is they haven't lost their capital," said Robin Lowe, head of equity hedge for the United States and Europe at Man Group (EMG.L). "This industry's about long-term capital growth, and that also means capital preservation ... If you are flat to slightly positive on the year and indexes are down around 10 percent, that's a pretty good outcome."

WHAT WORKED

Some strategies have found positive territory.

Investors who bet on corporate debt have fared better than most, as fixed income funds were up 4.72 percent in the first half, according to Hennessee Group numbers.

Distressed investing also fared well in the half, gaining 4.85 percent, according to Hennessee.

But some experts feel those strategies have run their course and expect investors to put their money elsewhere, favoring managers who bet on big events like mergers, make global bets on currencies and interest rates, or bet on specific stocks, going long or short.

"The hottest strategies right now are event-driven, equity long-short and global macro," said Carrie McCabe, who founded Lasair Capital after running Blackstone Alternative Asset Management and FRM Americas.

While global macro funds on average are flat, according to Hennessee, several macro-oriented funds that correctly bet on currencies and interest rates have seen outsized returns.

For example, Autonomy Capital, which oversees about $1 billion, is up 17 percent since January after gaining 3.6 percent in June, people familiar with the fund's returns said. And New York-based hedge fund Conquest Capital Group's macro fund is up more than 20 percent this year, making it the top performing fund tracked by HSBC.

Conquest, which manages $765 million in assets and also performed well in 2008, says its short-term trading strategy for futures and currency is designed to outperform in periods of high volatility. The fund, founded by UBS veteran Marc Malek, says it managed to take profits as markets were collapsing during the flash crash, and also benefited from bets on further stock market declines in May and declines in the euro and the British pound in the first half.

"This is really a great time to be in macro -- this amount of imbalance is what generates returns over the long haul," said MKP's Bonanca.

On the event-driven side, James Dinan's York Capital has gained roughly 25 percent over the last 12 months, according to sources familiar with the $14 billion New York-based fund's performance. Part of the reason event-oriented managers could deliver big gains in the second half is that worldwide growth hasn't picked up as quickly as many had expected, leaving companies ready to grow by acquisition.

INVESTORS TAKE A SECOND LOOK

In spite of the flat returns, demand for hedge funds has actually grown again since the financial crisis and is expected to pick up more in the second half of the year and into early 2011, investors and industry analysts said.

"These days, investors are asking themselves where do you put your money? Cash yields you nothing and real estate is not doing particularly well either," said Lasair's McCabe. "That leaves stocks and hedge funds."

As investors scout for investments, they will have plenty of new managers to choose from; more and more industry veterans are leaving their old firms to launch their own operations.

"Quite a lot of managers are leaving their firms and going out on their own, and at the banks a lot of people are concerned about the Volcker role and hence are looking to open their own shops," said Gravitas' Punater. Most recent launches have been in the $100 million to $500 million range, while a handful of new managers have raised over $1 billion, he said.

But the question remains how much money these relative newcomers will be able to raise. Some industry analysts said that in uncertain times investors would prefer to go with blue-chip managers who boast a long track record and have weathered previous storms.

"I like having money with people who have been through changing times before," McCabe said.