Picking a winning approach

Those invested in hedge funds over the past five years have realised the bene-fits of vehicles exhibiting low correlation to the equity and bond markets during a period of significant market dislocation. As we emerge from that turmoil, hedge funds continue to attract investors, especially those looking for a conserv-ative counter-balance to their existing traditional balanced portfolios.

For those new to alternative invest-ments, this can be a baffling arena. There are an estimated 6000 hedge funds in the marketplace, covering a plethora of styles and strategies.

In the words of many a compliance officer, past performance is no indication of future performance. The best-performing strategy was emerging markets, but this is not a strategy for the faint-hearted. At times it can produce seriously negative results. In 2000 the strategy returned –5.52 per cent and in 1998 –37.66 per cent.

A conservative fund of funds manager should hold avoiding risk as a central tenet. It is also crucial to invest in strategies that are easy to understand and operate within clearly visible margins of safety. The managers and strategies selected should have demonstrated success throughout vary-ing stages of the economic cycle. In this context and looking ahead to 2004, three strategies are worthy of discussion.

Distressed Securities

These were the second best-performing strategy in 2003, based on November YTD figures. The strategy focuses primarily on purchasing the debt of companies in financial difficulties and capturing the difference between the market price and the fundamental value of that company. In some ways this is the ultimate value trading strategy.

While many question how long the distressed boom will last, default rates have only just peaked and will not disappear overnight. Historically, the average bankruptcy cycle lasts 22 months and distressed specialists can make returns across the whole cycle from pre-bankruptcy through to emergence, including the “orphan” equity opportunities that often arise from re-organised, leaner, meaner firms.

Long/Short Equity

The success of long/short investing is dependent on a sustained broad market rally, that is, all stocks rising in unison, or whether uncertainty sets in about the pace of the world’s economic recovery.

While US and world equity markets were both up over 20 per cent in 2003, many of our long-short managers remained cautiously positioned. The weakening dollar, the pressure on the eurozone economy, fiscal indiscipline and global imbalance are particular areas for concern.

We believe there will be winning and losing stocks driven by company fundamentals. Competent long/short managers should be able to take advantage of both sides of this equation, going long on rising stocks and short on falling stocks.

Towards the end of 2003 we saw this in evidence as long/short strategies performed well and generated more than 14 per cent returns for the year to November.

Risk/Merger Arbitrage

Since 2000 the monthly global volume of outstanding M&A deals has been falling. But there are some initial signs that deal-flow may be creeping up.

Risk arbitrage managers typically make money by going long on the target of a merger announcement (with the expectation that the price will rise) and shorting the acquirer (whose price is expected to fall). While deal volume is vital to the success of this strategy, deal spreads are of equal importance, that is, the difference between the per-share value of an offer and the target’s stock price. Like volume, spreads have fallen since 2000 making this a tough market for merger arbitrage specialists. Many have exited the strategy.

Over the medium term, merger arbitrage could make a comeback. An improving economic outlook, capital market recovery, and low interest rates could well make the environment for strategic transactions more conducive to the strategy in 2004.

Michael Goldman is co-chief investment officer, funds of funds, Pioneer Alternative Investments