Market carnage after auto makers crash

Hedge funds appear to have been under attack from all sides recently. In April, Franz Muntefering, chairman of the ruling Social Democrat Party in Germany, joined in the criticism of hedge funds by describing them as “locusts”.

Some hedge funds are believed to have suffered significant losses from the earlier than expected downgrading of General Motors and Ford by Standard & Poors on May 5. They suffered a double whammy as both sides of their “hedge” went against them – they took long positions in the debt of GM and Ford and went short on their shares. This followed a very difficult month for hedge funds in April.

If the speculation is correct, many hedge funds invested through collaterised debt obligations (CDOs) also suffered. The equity part of a CDO is the first tranche to be hit by a fall in the value of a particular asset class and it thus pays out the highest yield to compensate for the greater risk. This is the part that was bought by the hedge funds while they took short positions in the safest portions of the CDOs.

Frederic Lebel, co-manager of the LODH Multiadvisers US Equity Long Short fund, says April was one of the worst months the convertible market has endured in recent memory. He points to the fact the HFRI Convertible Arbitrage Index lost 3.18 per cent during the month. He does not blame this on widening in credit spreads or volatility but attributes it to the “vicious circle brought by redemptions. These redemptions led to massive selling pressure, which resulted in a meltdown in liquidity and valuations, where losses have led to even more redemptions.

“Due to leverage, redemptions have a multiplier effect. The global event-driven sector declined by 1.15 per cent.”

He attributes the decrease in the HFRI Equity Hedge Index of 1.83 per cent to reversals in sector and stock trends that began in mid-March.

“The main feature of the sell-off was the shift away from cyclical stocks into more defensive sectors. Large-caps out-performed small and mid-caps in April and low beta stocks continued to out-perform high beta stocks. As a result, long/short funds experienced difficulties since they usually search their long ideas in the less researched area of small and mid-caps while shorting the more liquid stocks.”

Mr Lebel says macro managers (the index fell 1.44 per cent in April) were hit by losses in equity and currency markets. These losses offset gains in fixed income. “Commodities across the board experienced heavy losses. Energy in particular recorded the largest loss as crude oil prices tumbled from $59.20 (?48.24) at the start of April and closed at $49.50 at the end of the month. Metals showed a similar pattern, with aluminium and zinc being the big losers.”

David Smith, manager of GAM Diversity, says the drastic shift in market sentiment that took place in April, which proved difficult for the strategies held within this fund of hedge funds, should lead to fundamentals becoming more important again. “The selling occurred across most sectors and geographies and particularly in the cyclical and economically sensitive areas of the market.

“With the recent, aggressive sell off, managers feel that the majority of speculative money is gone and that – in the medium term – fundamentals should become the driving force behind performance. However, in the short term, with such strong macro headwinds, fundamentals are likely to be irrelevant.

“Performance from the arbitrage managers varied. April was a difficult month for arbitrage managers, although some were able to capitalise on the spike in volatility.”

However, Paolo Barbieri, deputy chief executive and head of fund of hedge funds at Pioneer Alternative Investments, says there have been over-reactions to the effect of the downgrading of GM and Ford on hedge funds. “It is not the case that the impact will be similar to the events surrounding Long Term Capital Management.”

But he admits the CDO market is relatively new and no one knows the full implications of so many managers holding CDOs. Mr Barbieri adds that it has been estimated that losses through CDOs by hedge funds and investment banks following the downgrades could reach $1bn (d830m). “The derivative markets for some debt is larger than the underlying market now. This raises questions about the impact of supply and demand on valuations.”

The main hedge fund strategy, says Mr Barbieri, to be hit by the downgrades of GM and Ford have been credit-related strategies and convertible arbitrage. Others, notably multi-strategies, will also have had exposure, but he believes investment banks’ proprietary desks will have suffered the majority of losses at around 65 per cent of the total. Mr Barbieri adds that most low volatility fund of hedge funds are highly diversified, which should limit the losses coming from their exposure to the above strategies.

Liquidity maintained

Mr Barbieri’s confidence about the restricted fallout from the downgrades is partly based on the fact that liquidity in the market has not been affected and there have not been redemptions by any of the underlying funds in Pioneer’s Momentum All Weather fund or its other fund of hedge funds.

He says: “If hedge funds are not forced to unwind positions, then they will only have suffered paper losses. The hedge funds could recover any paper losses they have suffered over the next few months. We have had no evidence of hedge funds having to liquidate positions.”

According to Mr Barbieri, Momentum All Weather has relatively small allocations to convertible and credit arbitrage strategies. “Our greatest exposure is to strategies that involve fundamental analysis, such as event-driven and distressed, rather than pure arbitrage.

“In event-driven, distressed and long/short equities, good fund managers can always find investment opportunities. In other strategies, such as a few of the arbitrage strategies, too much money flowing in can make it harder to generate returns.”

On the outlook for hedge funds, Mr Barbieri says the pick-up in volatility, as demonstrated by the bond markets and currency movements, will benefit managers. Many strategies require volatility to deliver strong positive returns.

“We hope there will be more volatility in the markets. It has been too low for too long. But at least what happened in the credit market caused a sharp rise in the risk premium across the board, which is beneficial to most hedge fund strategies,” he says.

The continued strong inflows into single and fund of hedge funds has concerned some professional advisers about future returns of certain funds, however. Tim Price, senior investment strategist of Ansbacher Wealth Management, says it has been reviewing fund of hedge fund performance over the past two years. Ansbacher’s clients have an average of around 40 per cent of their portfolios invested in funds of hedge funds.

“Our research suggests that the returns of large fund of hedge funds are becoming increasingly correlated with each other. And these returns are trending towards average performance,” says Mr Price. “They are producing hedge fund index like returns.”

Mr Price says Ansbacher’s caution is over asset managers with $10bn to $15bn in funds of hedge funds. “Managing such large amounts of assets can impact on performance in a number of ways. Funds of hedge funds typically cannot invest more than 10 per cent of their assets in a single underlying fund.

“This limits the potential universe for larger funds of funds. If they have more than $1bn in assets, they cannot invest in hedge funds with less than $100m.

“This situation rules out a potentially fertile hunting ground among hedge funds with between $20m and $100m in assets. There can be many reasons for hedge funds being this size, including a lack of marketing and being new launches.

“Larger funds of funds are missing out on good hedge funds at this end of the market. The hedge funds they will invest in will also tend to overlap with other large funds of funds. This leads to greater correlation of returns between the funds of funds.”

Another potential problem with larger funds of hedge funds, says Mr Price, is that it can be more difficult for them to switch between underlying holdings. “There can be liquidity issues in trying to move sizeable assets between hedge funds.”

Mr Price says that since May, Ansbacher has been investing new and existing client money in smaller fund of hedge funds groups, which tend to have less than $5bn in assets. “We are not moving money out of all the larger groups. We have invested with some fund of hedge funds for many years and are happy with their performance.”

The search for youth

The greater focus on smaller hedge funds with younger track records is picked up by Tracy Pearson, manager of the Forsyth Alternative Income fund. This is more diversified than other fund of funds as it holds around 80 funds. “We have a long tail,” says Ms Pearson. “The end of the tail comprises smaller hedge funds, many with relatively short track records.”

Ms Pearson has taken this approach partly because of the increasing speed at which it has been necessary to invest in hedge funds before they close to new investors. “We like having a diversified portfolio to reduce business risk. It can be advantageous to take an initial position with a new hedge fund and then grow with the fund.

“There is also an argument that the best returns by a hedge fund are delivered in the first 18 months of its existence. It can benefit a fund of funds, therefore, to find hedge funds in their first 18 months.”

Ms Pearson is bullish about the outlook for hedge funds after the difficult market environment on March and April. “Some hedge funds investors are looking to take tactical positions by going back into convertible arbitrage after the strategy was hit over the past couple of months.

“We do not take this type of approach to investing. Some investors have also taken positions in high yield after spreads widened. “The first quarter of the year was difficult for hedge funds. But managers are finding plenty of value at the moment. It is important to remember that hedge funds adapt their strategies. When people said the environment was difficult 18 months ago, hedge funds turned to consumer finance and loans, leading to returns of 1 per cent a month again.”

One way of trying to reduce volatility within hedge fund strategies is by gaining diversification through fund of hedge funds.

Carl Dunning-Gribble, head of marketing and sales at at the Alternative Investment Products Group at Crédit Agricole, says: “We can achieve superior risk-adjusted returns through diversification across all our specialised alternative strategies. We see risk management and control over our investments as a cornerstone of our investment approach.

“Quantitative as well as qualitative analyses are key to the selection of individual hedge funds specialising in alternative investments. We favour low volatility and constant return over explosive return with high volatility.”