Omens look good for hedge fund returns this year

Date: Monday, April 17, 2006
Author: Reuters.com

By Pratima Desai

LONDON, April 13 (Reuters) - Hedge funds delivered strong returns in the first quarter of this year and with market volatility expected to rise and clear trends evident in currencies and bonds the omens for 2006 are good.

So far this year hedge funds have delivered average returns of about 4 percent compared with 7.5 percent for the whole of last year.

Taking into account the summer lull, hedge fund investors say a simple extrapolation through to the end of the year could mean average returns of between 12 and 15 percent in 2006.

"It's been a good start ... There is a very good chance that we will do better then we did last year," said Ian Morley, chief executive at Dawnay Day Olympia.

"Hedge funds are an insurance, a way to protect capital during stock market down periods ... Most people only remember that when equities crash."

Whether hedge fund returns do exceed those of equities this year remains to be seen and few are prepared to forecast the sort of event that could trigger a major stock market correction.

But the fact that wealthy individuals, who are usually ahead of the game and who have been heavily invested in stocks for the last three years, are once again focusing on hedge funds is a clue that equity market sentiment could be turning negative.

If hedge funds do beat stocks this year it will be the first time since 2002 when they returned an average around 3.0 percent compared with losses of 19.5 percent for the widely-watched benchmark MSCI index <.MSCIWD> of world stocks.

"It's terribly difficult to predict what's going to happen ... That's not really our game," said Alastair Altham, chief strategic officer at Lionhart Investments.

GAME

So what game do hedge funds play?

One claim, contested over the last year, is that hedge funds offer consistently high returns adjusted for volatility.

Another is that they preserve capital because they offer above zero or absolute returns and can use derivatives and short sell -- gamble on a lower price for a security in the future -- to protect against and benefit from price falls.

"Hedge funds need either a clear trend, it doesn't matter which way, or they need volatility," said Ashok Shah, chief investment officer at London & Capital.

"The opportunity set was quite good for them in the first quarter and it remains as good in the second quarter."

Hedge funds have sold the dollar on the basis that the U.S. economy will come unstuck this year and some are betting on higher U.S. Treasury bond yields because they think the U.S. central bank is unlikely to halt interest rate rises at 5.0 percent in May.

They are active in commodity futures and emerging markets, which because of expected volatility, will offer opportunities on the downside as well as the upside.

"It's going to be a good year... because of the fact that the environment is right for there to be ample opportunities for skill-based investors," said Dawn Kendall, investment director at GAIM Advisors.

In relative value strategies, which buy and short sell securities against each other, the potential to make money is greater then it has been for a couple of years.

Convertible bond hedge funds for example returned around 4 percent in the first quarter of this year after nearly two years of flat or negative returns after the number of both new issues and volatility collapsed.

The stronger performance this year is partly due to convertible bonds being historically cheap and partly because volatility, which creates mispricing, appears to be returning as stock markets approach a turning point.

Many investors believe that the uptrend from the lows of 2003 has now run its course and a correction this year is likely.

"The question to some extent is how hedge fund managers react to and deal with the inflexion point," said Gavin Rankin, head of investment analysis in Europe at Citigroup Private Bank.

"If the inflexion point occurs and they are not prepared, then you are likely to see a significant change in terms of hedge fund returns."