Standard & Poor’s Fund Services warns fund-of-hedge-fund investors

Date: Wednesday, August 16, 2006
Author: S&P

Standard & Poor’s Fund Services has issued a warning to investors in funds-of-hedge-funds based on its latest research on the sector.

“Investors may need to think carefully about market conditions despite hedge funds’ general aim for absolute returns at all times,” said Standard & Poor’s fund analyst Randal Goldsmith, “In addition to remaining alert as to what might cause a market correction, it may also be important to take a look at whether funds are showing more correlation over time and whether their portfolios are taking more exposure to equity long-short and macro compared with arbitrage and fixed income related strategies.”

Goldsmith explained that funds-of-hedge-funds generally implement asset allocation changes more slowly than conventional, long-only funds, due to such things as redemption notice periods and lock-ups, noting “So if a fund-of-hedge funds participates in equity market rallies, it is likely to suffer in a sudden correction.”

An unexpected development during the most recent correction was that many fund-of-hedge funds actually fell more than related equity indices. Reasons for this included a general overweighting of small- and mid-cap stocks versus large-caps, exposure to commodities and to emerging market equities. Said Goldsmith “Investors might have been upset by the returns provided by many fund-of-hedge funds, claiming to be independent of market direction.”

He cautioned investors against comparing the recent sell-off to the bear market of 2000-2003, when the main feature was a correction of extreme overvaluation of technology and related stocks. “Hedge funds did well in that last bear market but they had a more difficult time in the liquidity squeezes of 1994 and 1998,” he said, pointing out the similarity with the recent equity correction, driven by the removal of liquidity by central banks, and in particular the ending of the zero interest rate policy in Japan.

Standard & Poor’s Fund Services’ research showed that the funds-of-hedge-funds that did best during the second quarter of 2006 were those with a bias towards arbitrage, trading and fixed income related strategies. Strategies such as convertible and volatility arbitrage benefited from the rise in equity market volatility, with the VIX index reaching its highest level for three years on 13 June 2006. Permal High Yield Holdings (+0.6%), Liberty Ermitage Asset Selection (+0.6%) and RMF Four Seasons (+0.4%) all had a relatively good quarter. RMF’s Event Driven Fund (+1.5%) had a good month, although its core strategy did not have a good quarter. However, the fund also invests in special situations, credit and distressed, all of which had a strong quarter.