Hedge funds need rational markets

Historically, hedge funds have performed worst in and around the focal points of significant market dislocations. This was no more apparent than in September and October of 2008, when hedge funds delivered some of their worst monthly numbers ever. The sudden reversal of trends and drastic, technicals-led price movements tend to undermine most hedge fund investment strategies.

By consequence, many managers often struggle to protect capital through such selloffs. However, once the initial trauma subsides, hedge funds have tended to outperform in periods following such dislocations even when broad market conditions remain very poor.

In February 2009, while market conditions did indeed remain very poor, it has been suggested that the level of uncertainty abated somewhat, enabling managers to use the tools at their disposal to position themselves advantageously. This resulted in hedge funds protecting capital and, in some cases generating positive returns in February against the backdrop of a large equity sell-off. This is illustrated by a comparison with the major market indices; the S&P 500 fell 11 per cent over the month – its third worst monthly return of the last ten years. In Europe the FTSE EuroFirst 300 Index fell by 9.7 per cent, while in Japan the Topix fell by 4.7 per cent in February. By contrast, hedge fund performance in February was modest in an absolute sense but impressive from a relative perspective, as the Credit Suisse/Tremont Hedge Fund Index was down just 0.9 per cent, thereby remaining in positive territory year-to-date.

a more familiar climate

How have conditions changed to facilitate this improvement in the investment environment for hedge funds? One suggestion is that the ongoing stream of bleak news including deep levels of consumer pessimism is becoming more predictable. Indeed a recent Goldman Sachs research piece commented: “In short, the macro backdrop may not be much better than in November, but it seems a lot more familiar. And in this uncharted environment, familiarity is probably a good thing.”

The reason for this, the piece suggests, is because the economic climate is beginning to feel more and more like a “classical recession” (“albeit an extremely nasty one”). Evidence for this is reflected in the Vix index, which indicated that while volatility levels remained high, they were consistently so – holding a narrower range than has been witnessed in the last few months. Perhaps then an uneasy concord has fallen into place as behaviour becomes a little more rational and markets stop bouncing from shock to shock.

The danger for hedge fund managers, who seem to have got to grips with the current terrain, is if something happens to suddenly jolt investor expectations away from the status quo. On the upside, this could be an unexpected cluster of positive economic data, instigating the type of fierce rally which could see managers racing to cover their shorts. To the downside, one of the most destructive scenarios could be further collapse in the financial sector, unleashing another wave of deleveraging from which few portfolios would be safe.

The message hedge funds are perhaps reminding us of is that they do not necessarily require a growing economy or bullish markets in order to be successful, they simply need a coherent narrative whereby markets are trading with a degree of rationality. Many managers would argue that losses accrued in 2008 were due to the absence of such a narrative – replaced instead with a vacuum of fear and uncertainty which rendered many investment strategies impotent.

Hedge funds may not be out of the woods yet, but there is growing substance to the idea that we have transitioned to an investing environment in which the best managers can generate good returns. Investors must weigh up whether the risks are sufficient for them to remain on the sidelines, or whether the strong performance of many managers now warrants a more active approach.