Staying in the game in a much-changed world

Mon Sep 29, 2008

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By Neil Wilson

Market events this past month - from the U.S. government support for Fannie Mae and Freddie Mac to the filing for bankruptcy by Lehman Brothers and the bailout of AIG - have come so thick and fast they have no doubt left many outside the hedge fund world reeling with bewilderment. But within hedge fund land, there already was an acute focus on just how well - or badly - hedge funds, individually and collectively, cope with the market turmoil. Everybody knows that how the funds perform through this treacherous period is likely to be crucial to future prospects in a much-changed financial world.

After the first half of the year, I felt on balance that hedge funds had generally done not too bad a job of coping with truly challenging conditions. Of course, some had major problems - such as Peloton Partners, which imploded so spectacularly in February. And returns delivered by individual funds were widely dispersed - with many nursing double-digit losses.

Nevertheless, the median returns for the first half were roughly flat - not great, admittedly, but much better than equity markets, which were down 10% to 20%, and most other asset classes. This included strong performance from CTAs and other commodity players, macro funds and volatility strategies - which balanced out losses in other areas. In Europe, three of the biggest players by assets - the AHL futures program operated by Man Group, the Brevan Howard macro strategy, and David Harding's Winton Futures - were all up strongly in the first half and are still well in positive territory for the year to date.

Some other areas were also surprisingly resilient. As measured by the EuroHedge European Long/Short GBP index, long/short equity funds investing in Britain were up an average of more than 4% in the first half - with many managers successfully playing a short financials and/or a long mining and commodities theme.

In July and August, however, trends in both financials and commodities suddenly reversed, hitting many funds that had previously done well this year - with relatively little in the way of compensating gains elsewhere. By the end of August, the HedgeFund Intelligence Global Composite of performance slipped to -1.37% for the year to date. But once again, the overall median disguised some massive dispersion. If hadn't been for the fact that CTAs - often derided in previous years as poor relations of "real" hedge funds - were up nearly 8%, the Composite would have looked considerably worse.

The epicentre of the carnage has been in Asia and emerging market equities. For some time, skeptics had been warning that these funds were "long-only players in drag" - and sadly, this appears to have been true of all too many. The difficulty, expense and, at times, sheer impossibility of hedging in some of these markets have no doubt also been factors in losses averaging nearly 16% so far this year for emerging market equity funds, and even greater average losses for funds in Asia excluding Japan, particularly in India and China.

Some will no doubt already be saying this signals the death knell for hedge funds in those markets. There was indeed a drop in assets for the first time on record in Asia-Pacific hedge funds during the first half of 2008 - of about 10% from some $192 billion in January to less than $176 billion by July, according to the latest AsiaHedge survey.

I would say, however, that we shouldn't draw too many sweeping conclusions too fast. For one thing, quite a few funds have continued to deliver excellent positive returns in Asia over the past year - from such groups as Artradis Fund Management of Singapore, Coupland Cardiff Asset Management and the Gartmore Japan team in Tokyo - which are all among a stronger-than-ever field of contenders vying for recognition at the AsiaHedge Awards in Hong Kong this month.

It seems to me, however, that some structural changes are likely in the makeup of the hedge fund market. Strategies that focus primarily on more liquid, heavily traded instruments must surely come back even more into vogue. And many strategies that focus on less-liquid instruments and/or require heavy degrees of leverage must surely get squeezed.

That doesn't mean highly attractive opportunities won't appear in some less-liquid areas of credit and distressed debt instruments. But investors should be aware that, with the levels of volatility we have now, managers should not need leverage to exploit them.

ISSN: 2151-1845 / CDC10004H

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