Hedge funds depend on beta as they ride careening equities

Date: Tuesday, November 2, 2010
Author: Christine Williamson, InvestmentNews

Returns beat S&P, MSCI World Index over first three quarters

Hedge fund managers are having a hard time making a buck this year, unless they get a boost from a whole lot of market beta.

“It's been all about beta this year,” said hedge fund consultant Howard B. Eisen.

“Hedge fund managers have been net long equities all year, and in May, the market clocked them. But in September, they rode the wave,” said Mr. Eisen, managing director of FletcherBennett Capital LLC.

Hedge fund returns were particularly strong in September, with major indexes turning in their highest monthly returns since May 2009, though sources said the surge was driven by extremely strong equity markets. Still, domestic and global equity market returns were even stronger, with the S&P 500 returning 8.92% and the Morgan Stanley Capital International World Index at 9.6%, leaving the best-performing hedge fund index, the Barclay Hedge Fund Index, lagging at 3.57% for the month.

Over the first nine months of the year, however, the 5.2% return of the Barclay index surged well ahead of the 3.91% return of the S&P 500 and the 4.1% return of the MSCI index.

“It has been a challenging year for hedge funds; they have struggled to generate alpha in an environment of high correlation and high volatility. That said, hedge funds are still outperforming equity markets year-to-date,” Lee Hennessee, managing principal of Hennessee Group LLC, said in a statement.

“When everyone is buying and selling at the same time, it's extremely hard to make money,” said one fund-of-hedge funds manager, who asked not to be identified.

“About the best you can expect from long/short equity managers, for example, is a ride on market beta. There's just not much dispersion between the best- and worst-performing stocks — everything is being rewarded or punished equally — and not much dispersion between long/short equity managers,” the manager said.

Industry sources said institutional investors could be pleased about hedge fund managers' strong positive year-to-date returns but likely will not be happy to pay high management fees of 2% and performance fees of 20% for returns that are so closely tied to the performance of global equity markets.

Whether they are net long equities or not, managers of equity and multistrategy hedge funds were plagued by persistent, sweeping macro trends that significantly raised correlations between individual stocks and between stock markets worldwide.

'HUGE CORRELATIONS'

Those global macro factors — including currency movements, monetary and fiscal policy, sovereign-debt problems, stagnant economic growth and government quantitative easing — spooked investors, who bought and sold en masse throughout the first three quarters, market observers said.

Those big-picture reactions have led to “huge correlations between not only individual securities but also between different markets,” said veteran multistrategy hedge fund manager James G. Dinan, chairman, chief executive and founder of York Capital Management Global Advisors LLC, which managed about $14.1 billion as of Sept. 30.

Using the median 90-day correlation of 0.72 among the stocks of the S&P 500 as of Sept. 30 — very close to its historic high over a 10-year period of 0.79 reached in July — “is a very effective way of showing the dominance of macro factors on stock market returns in recent times and its implications for hedge fund investing,” said Deepak Gurnani, managing director and chief investment officer of the $5 billion hedge fund and fund-of-funds business of Investcorp International Inc.

“Equities are so correlated worldwide that it's obvious that what's driving returns are macro trends. Most equity managers are not doing a very good job of factoring in macro trends, and it's a drag on their performance,” Mr. Gurnani said.

“There is not a lot of differentiation among securities ... correlation is high, and most investments rise or fall with the market tide,” said Greg T. Fedorinchik, managing director of Mesirow Advanced Strategies Inc. “A fundamental manager that is buying cheap stocks and selling or shorting overvalued stocks struggles in that kind of environment because the beta effects swamp the security selection effects. Everything does well, even the [stocks] he or she is short. They can't generate a lot of alpha when all stocks are rising and falling together, regardless of quality.”

Mesirow managed $12.9 billion in funds of hedge funds as of Sept. 30.

Managers such as Mr. Dinan can do little but ride out the market.

“The fuel for the latest round of volatility is the market's fear of a double-dip recession and algorithmic trading. Algorithmic trading is driving equity correlations by distorting valuations and distorting investor confidence,” Mr. Dinan said. “I don't think we're in a secular trend; it's just cyclical. It's not impossible to make money in this environment, but it can be difficult.”

Mr. Dinan and other multistrategy managers can “look under the rocks,” as he put it, to find opportunities to generate alpha in other asset classes. Mr. Dinan said he's “pretty bullish” on opportunities in European credit markets, for example.

Credit markets worldwide also have been affected to a lesser extent than equity markets by “macrolike thinking,” said credit specialist Stephen King, founder and CIO of C12 Capital Management LP.

“The interesting thing in the last year is the definitional point regarding what is considered credit, fixed income, etc. Before 2008, most credit approaches were directional, single-strategy funds that were down in the weeds, not very cognizant at all of externalities that could affect performance. The market crisis really changed that. There's been such a muddying of the waters this year. With so many credit-related strategies coming together and with more correlation between them and across markets, fundamental credit managers have to take a macro view and look at more than their own local environment,” Mr. King said.

As of Sept. 30, C12 managed $13.7 billion in credit strategies.

For hedge funds focused on completely uncorrelated asset classes such as commodities, 2010 has been something of a breakout year regarding increased interest from institutional investors.

Commodities specialist Vermillion Asset Management LLC, for example, has seen strong institutional inflows this year into both its alpha hedge fund and long-only beta funds. Assets totaled $1.5 billion as of Sept. 30, with new net inflows year-to-date of about $500 million, mostly from sovereign-wealth funds and pension funds, said Christopher Nygaard, the firm's managing partner. He noted that the firm's pipeline of potential clients is swelling as institutional investors seek uncorrelated strategies.

“Under normal circumstances, commodity returns tend to be schizophrenic versus other asset classes, and institutional investors are taking notice,” Mr. Nygaard said.

Christine Williamson is a reporter for sister publication Pensions & Investments.