Have all the wrong lessons been learned from the liquidity crisis?

Thu Jun 23, 2011

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Who would want to be a fund of funds manager right now?

By Nick Evans

It is difficult enough for hedge fund managers to find ways to make money, or avoid losing money, against such a volatile and uncertain market and macro backdrop – as the disappointing European hedge fund performance so far this year shows.

For fund of fund managers – faced with the added challenge of providing end-investors with a return net of that extra layer of fees, while having to retain sufficient liquidity to avoid a repeat of the liquidity mismatch that nearly killed them in 2008 – the problem is worse.

Performance numbers this year make for sobering reading. After another bad month in May, the EuroHedge Composite index stands at 1.2% on a median basis so far this year – and at less than 1% on a mean average basis.

The provisional estimate for the InvestHedge Composite Index shows a year-to-date median return of some 0.8% to the end of May for all funds of funds – and of just 0.3% for European multi-strategy funds of funds.

Even with cash rates at effectively zero, these are hardly returns to get investors excited – and the performance does little to convince those already sceptical about the value that such intermediaries really add.

To be sure, this is not an easy investing environment. The macro and market mood is jumpy to put it mildly – with the commodities rout in May and the escalating crisis over the Greek debt restructuring in June being just the latest outbreaks of extreme unease.

And it looks like being a nervy summer ahead – with fast-reviving fears of a full-blown Eurozone sovereign debt crisis, the alarming prospect of a US debt crisis and the biggest unknown of all in terms of the impact of the US ending its QE stimulus programmes.

Deciding where to put your money, against such a febrile and fearful backdrop, is made a good deal more difficult by the knowledge that nobody – either a hedge fund or a fund of funds – can afford a repeat of the problems that caused such reputational damage in 2008.

After the crisis of 2008 and 2009, liquidity became the mantra for investors – most of all for the funds of funds. So it is all the more ironic that the three core strategies that investors identified as the most liquid, transparent and ‘safe’ places to invest – long/short equity, macro and managed futures – are the only three that are down for the year so far.

All other strategy areas have delivered positive returns – led, of course, by the very same strategies that investors have turned away from on the grounds of illiquidity, complexity or lack of transparency.

Convertible arbitrage – which most investors have abandoned altogether – is out in front. Credit, again mistrusted by many, is next. And third is emerging market debt, a growing but still relatively small and very under-allocated area.

So this rather begs the question of whether the wrong lessons have been learned since the crisis – and whether it is actually in the illiquid, non-transparent and complex areas that hedge funds are best able to make money, particularly in difficult markets.

One could go further. Did gating actually hurt investors, for example – as so many have moaned about? Or did it do what it was supposed to do, which was to save them from their own folly and stop them all baling out at exactly the wrong moment?

And why should investors see hedge funds as liquid investments? They don’t do that with property or private equity, for instance – so why hedge funds? After all there are plenty of other ways of getting liquid and cheap exposure to markets and hedge fund-lite strategies – through ETFs, mutual funds, UCITS absolute return funds, index replicators and the like.

So perhaps we are rediscovering some old truths about hedge funds: that there is a premium for illiquidity, that what you should be looking for and paying for is skilled investing rather than cash management, and that hedge funds are probably not the best place to put your money if your primary fixation is whether you can get it back tomorrow.

It is an inescapable fact that the more liquid an investment strategy is, or is required by its investors to be, the more likely it is to be correlated to the underlying performance of the markets in which it invests – which, in the current climate, is unlikely to be very compelling.

As the old adage goes: if you want liquidity, buy a government bond – assuming you can find a government these days that is likely to be able to repay it.

ISSN: 2151-1845 / CDC10004H

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