Are investors prizing protection over profit?

Fri Sep 21, 2012

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The ‘new normal’ seems to be a bi-polar psychology that veers between outbreaks of panic and relief

By Nick Evans

The summer lull is over - after the most drama-free August, in the financial world at least, for many a year - and it's back to reality with a strong sense of déjà vu.

All eyes remain on the central bankers and their 'unconventional' monetary policies, with markets increasingly hooked on liquidity interventions and increasingly despondent about global growth prospects.

In the US, Bernanke has pulled the trigger on QE3 - hoping to kickstart (again) a US economy that badly needs a boost ahead of what is shaping up to be the most polarised, divisive and plain nasty election in years.

In Europe, Draghi has also delivered what the markets had been clamouring for - despite opposition from an irritated Bundesbank - with his potentially game-changing OMT bond-buying programme (the successor to the SMP). And the BoJ and the BoE are both in on the act too.

Acronyms abound - not least in Europe, where the alphabet soup of financing facilities and mechanisms set up to deal with the debt crisis is mind-boggling. But the only appropriate one at this stage is perhaps the famous army term of SNAFU (situation normal, all f***ed up).

Although market sentiment has been upbeat of late, fear is never far away. And, with two thirds of another difficult year now gone, hedge fund managers are still on trial as to whether they can deliver the goods for investors in a market environment where the 'new normal' seems to be a bi-polar psychology that veers between outbreaks of panic and relief.

Given that global markets were up by 8% even before the central bank-fuelled September rally kicked in, the fact that the average European hedge fund was up by only 2.5% to the end of August does not present a very compelling case for investing with alternative managers, if returns are what investors are looking for.

Some types of strategies have done much better than that - such as value-based equity managers, many credit and converts funds, a few selected macro, CTA and trading strategies and so on - and there are plenty of individual funds that have generated genuinely impressive double-digit performance in a very testing environment.

But, for most investors - certainly for the institutional pension fund-type clients and the super-wealthy individuals that increasingly dominate the hedge fund investor universe - returns are not the primary concern at the moment.

Risk is the over-riding worry - the risk of another big market crack; the risk of a renewed systemic crisis in the financial sector; the risk of a political and economic catastrophe in Europe; the risk of a major geo-political event in an unstable and volatile world; the risk of inflation eroding capital; the risk of a global economy with flagging or virtually non-existent growth.

Ever since hedge funds began, those who see them as an asset class have loved to debate over whether they should be seen as an equity-type or bond-type investment. For many years, this seemed like a rather arcane argument that was arguably missing a wider point - which was that hedge funds represent individual styles of managing money, not an asset class per se.

But perhaps, in an environment like this, that question is only fundamental to investors' shifting perceptions of what it is that they want hedge funds to do for them - and what they are prepared to pay them for doing it.

In an ultra low-rate, low-growth, low-confidence climate, aspiring to achieve outsized equity-type returns looks to be a tall order without taking some fairly outsized risks - while equities appear to have as much downside as upside potential and top-quality government bonds must surely be nearing the point where they can only be seen as offering 'return-free risk'.

Against such a backdrop, providing bond-style downside protection with modest, low-volatility positive returns is not such a bad prospect - assuming, of course, that hedge funds avoid the worst of all worlds by contriving to deliver bond-type returns with equity-type risk.

From the point of view of managers without sufficient scale to be able to rely on management fees to keep their businesses ticking over, this may not be a terribly appealing prospect. But, for investors, that may well be what they are looking for in a climate where managing risk, preserving capital and minimising volatility are the paramount objectives - and when they already have plenty of exposure to market directionality elsewhere in their portfolios.

So perhaps it is that more than anything that is persuading investors to keep faith with their hedge fund allocations - despite the less than stellar performance by most of their managers.

Paying 2% and 20% (or variants thereof) for negligible absolute returns may not be ideal over the long run. But if - in the shorter term - it offers some protection against another potential catastrophic loss, many investors may be concluding that it is probably a price worth paying.

Then again, if the risk rally keeps going....