By Neil Wilson
Several speakers at this years EuroHedge Summit, the European hedge fund industrys annual gathering in Paris, expressed marked optimism about the unfolding opportunity for hedge funds in various asset classes, creating a palpable buzz among the nearly 900 delegates in attendance.
That said, several other speakers expressed numerous concerns about uncertainties in the outlook for the future. These were partly to do with the likely array of new regulatory requirements facing the industry around the world. But they had more to do with some deep worries about the global macro environment.
Over the course of the two-day conference, speakers repeatedly mentioned rising food prices, growing social unrest and the probability of sovereign debt defaults and/or restructurings.
At a time of extreme volatility in oil prices and in other commodity and currency markets, the one thing that came up again and again was the specter of rising inflation, or the possibility of a prolonged period of stagflation such as the one that occurred in the 1970sand how to protect the value of assets, let alone generate real returns, in such a challenging environment.
If such a period lies ahead, the main question about how to respondsuperficially, at leastlooks to be about how much exposure to take to gold. In any period where there is a loss of confidence in the value of paper money, whether it be the dollar, euro, pound or yen, gold is usually pointed to as the most obvious safe alternative, most likely because it has been used exactly as such a store of value for millennia.
This notion generated a considerable amount of discussion during the conference. One of the keynote speakers, Colm OShea of $5 billion macro shop COMAC Capital, struck a circumspect note.
In his Q&A session with the audience, OShea highlighted that, unlike other commodities, gold is not really useful at all, in the sense that it is in plentiful supply yet not used for anything much besides jewelry. Gold is useful, he pointed out, only if you can use it to acquire things that are actually practical, such as other commodities that you can eat or use to generate energy or to produce manufactured goods.
Another keynote speaker, Lee Robinson of Trafalgar Asset Managers, noted that despite the recent run-up in the price of gold, the vast majority of investors still have little or no exposure to it. He argued that investors should have at least some exposure, though he parted company with the gold bugs on some aspects of their analysis. Instead, he offered various option-based trades that investors could deploy as more sophisticated ways to hedge or play the current market.
While this sort of debate raged over two days, one thing that Robinson said struck hometo me, at leastparticularly forcefully: If there is indeed a period of higher inflation, investors will no longer be looking at hedge funds in terms of nominal returns, or even in terms of returns relative to benchmarks such as equity indices.
They will be judging them increasingly in terms of real returns, relative to inflation, and rightly so.
Robinsons view was that hedge funds, where managers can undoubtedly deploy a wide armory of investment strategies, should be better placed to protect investors than other investment styles and classes.
The best industry to benefit from the investor focus on real returns is the hedge fund industry, Robinson told the packed hall of delegates in Paris. We have the tools and the ideas and the flexibility to make real returns.
Theoretically, that may be the case. But to me it looks like a significant challenge. Hedging strategiessuch as the short sides of long/short and arbitrage investingcost money and tend to flatten returns. That can be effective in reducing volatility and delivering solid risk-adjusted returns, as many funds have shown over long periods.
But investors should remember that the last time the industry went through a prolonged period of rising inflation, in the 1970s, the vast majority of hedge funds failed to keep pace with inflation and ultimately failed to survive.
Only a minority, mainly macro players like George Soros who made the right directional bets, came through successfully. If the benchmark for success rises from the risk-free rate (which is now close to zero in most major currencies) to an inflation rate nearer to double digits a year, it will make a much more difficult environment for a lot of hedge fund strategies.
Some strategies, such as macro funds or CTAs or volatility players, may thrive in such an environment. And there may be deep value that emerges in some equity or distressed strategies as well. It shouldnt mean the end of hedge funds, because some managers will flourish and many should still survive. But its likely to be a bumpy ride.