With markets going through yet more gyrationssparked partly by the S&P downgrade of U.S. Treasury securities and amid recurring concerns about European sovereign defaultsmany investors will no doubt have spent an anxious August holiday. Many will have been thinking: Are we about to witness a rerun of late 2008?
It is not a pretty thought. Last time, after Lehmans collapse, a complete meltdown was averted only by a huge bailout of the banks by Western governments. This time, the governments themselves are teetering, and nobody, it seems, has the resources to bail them out.
For the hedge fund industry, 2008 was in many ways an annus horribilis. It was a year when the HFI Composite median did not look that bad (down only about 7%) but when mean average returns were down more about 15% to 20%. And it was a year when many individual funds angered investors by gating or suspending redemptions.
Yet 2008 was also a yearas I argued strongly at the timeof many heroic individual performances. A significant minority of funds were up, including some in almost every strategy area. For instance, Brevan Howards flagship macro fundthe biggest hedge fund in Europe with assets of more than $20 billiondelivered a terrific return above 22%. And Horseman Global Fund, then one of the worlds biggest global equity funds, gained more than 31%.
In 2008, one strategy in particularmanaged futuresdemonstrated a true capacity for noncorrelated returns, with the average CTA rising an impressive 15% to 20%. Many were up by a lot more, led by funds like BlueTrend, the BlueCrest Capital Management systematic strategy, which gained more than 44%.
Overall, hedge funds were down in 2008, but with returns still much better than the equity markets (which fell about 30% to 40%).
In 2009, performance was also pretty strong. Having protected investors from at least some of the downside in 2008, hedge funds also captured most of the recovery, with the HFI Global Composite median up by more than 12% (and mean average returns closer to 20% if you exclude the CTAs). In 2010, returns were not so exciting but again pretty respectable, with the HFI Composite median at close to 8%.
The most disappointing period of performance, arguably, came most recently, during the first half of this year, when hedge fund returns on average were more or less flat. In that period, hedge funds delivered little or no absolute return and did not outperform equity markets either, as many managers appeared to get repeatedly wrong-footed by whipsawing patterns in the markets. That left performance so far this year looking uncomfortably similar to 2008, when hedge funds also had a flat first half, which led into six straight months of negative returns that year (from June through November).
In short, the marketsand returns so far this yeardo not look pretty. Just how tough it has been is perhaps best reflected in reports that even George Soros, arguably the most talented fund manager in history, had liquidated most of his positions, even including exposure to gold, and gone mainly to cash.
On the other hand, where there is great difficulty, there is also opportunity. And if markets do go through another period of upheaval and convulsion, hedge funds should get a chance again to shine, just as in 2008, when a significant minority truly did deliver.
One might expect that some of the same sorts of strategies that worked in 2008such as the CTAs, global macro and volatility playerswould work again in similar circumstances. But if there are sovereign defaults, then there may be new and unforeseen sorts of market dislocations.
However, there may also be other strategies that excel next timeincluding long/short equity funds and/or credit, distressed debt and multistrategy hedge funds, who may well be able to seize a once-in-a-lifetime opportunity.
I do not dare to predict who will do well. That is more properly the job of professional allocators, including the funds of funds, who may also have a huge opportunity to prove their worth (and in some cases, redeem themselves after a poor 2008) by picking the winners in the coming period.
It does look like a rough ride ahead. It could be a crucial test not merely for hedge funds but for the whole western system of capitalism. After so many crises and major market eventsfrom the dot-com bubble to the Lehman collapsethis sovereign debt crisis could prove to be the ultimate stress test.
Nevertheless, I still firmly believe that there are hedge fund managers who can and will demonstrate the ingenuity and skill to navigate through this period ahead. It will be very interesting to see how many can do it and which ones they will be.