By Nick Evans
Hedge funds needed May like they needed a hole in the head. After the strong recovery in 2009 and a generally good start to this year, along came another unwelcome reminder of the industry's continuing vulnerability to big market drops and dramatic spikes in volatility.
But how bad was it really? And has the case for hedge funds generating uncorrelated returns been weakened as a result? To both questions the honest answer is a rather hedged one. To the first: bad, but not a disaster. To the second: no, so long as it is a one-off.
To be fair, equity market volatility was off the charts in May. The 2% fall in the overall EuroHedge Composite median index has to be set in the context of European equity markets that fell around 5% on the month, with some markets down much more - and of whipsawing intra-month, intra-week and often intra-day volatility that has rarely been seen before.
"The worst May for several decades in many equity markets". "The worst May for the market since 1940". "The most volatile markets for 50 years". These were just some of the descriptions in managers' newsletters for May. So it is not entirely surprising that the majority of hedge funds, particularly those focused on equities, were down on the month.
But it could have been much worse. Despite the drawdowns, most managers are still positive for the year - or only narrowly down - and overall, the EuroHedge Composite index is flat for the year against market indices that are well down.
Nobody with any experience or understanding of hedge funds is under any illusion that they can - or should - make money in all market conditions. Not unless they were related to Madoff, that is.
And the events of May - which could easily be repeated, in an environment where uncertainty and volatility reign - serve as a reminder that the primary purpose of hedge funds is not to provide investors with additional correlated exposure to markets, but to enable them to participate in market upside and to protect them on the downside.
Did they do that in May? Up to a point. It is always dangerous to generalise with hedge funds, but in general the majority did do a half-decent job of protecting their investors in a wild month.
That said, it is notable that many of the larger equity funds - and some of the larger funds in other strategy areas, like CTAs and macro for instance - were down rather more than the averages in May, and in some cases by rather a lot more. On a capital-weighted basis, the index would have been down a fair bit more than 2%.
Of course any hedge fund's performance must be judged over a period or a cycle - not just over a single month. And very few hedge funds in any strategies are specifically set up to profit from falling markets.
But, in such an uncertain and unclear world, managers and investors will probably have to get used to living with intense outbreaks of volatility - and with uncertainty at every level.
The markets could well be in a period of what old stockmarket hands would recognise and characterise as "range-trading" - marked by bouts of ferocious volatility along the way.
Or they could be poised for a major directional move - upwards or downwards. As one manager recently put it: "You could just as easily see a 25% rise in equity markets this year or a 50% fall".
It is an exceptionally challenging and confusing climate in which to be managing money - and it would be hard enough without the added layer of uncertainty surrounding the whole regulatory 'reform' of the financial industry, the banks and hedge funds themselves.
So there are mitigating factors for May's performance - and investors are unlikely to make any decisions on the basis of a single month, particularly after an 18-month period when most hedge funds have performed well.
But the May turmoil should also serve as a wake-up call. Hedge funds are a 'stay rich' investment vehicle, not a 'get rich' one. For most investors, capital preservation and downside protection are of overwhelming importance.
As the industry has grown, it is inevitable that there is increased beta in the overall returns from hedge funds - and overall performance is unarguably more correlated with market direction than it was in the past.
But these kinds of markets should - in theory at least - provide the right climate for hedge funds to assert their value in terms of providing downside protection and capital preservation. And the onus is on managers to prove that they can do that in the most testing of conditions.
Investors will forgive the May performance. But they will not forgive too many repeats.