While hedge funds are still attracting net inflows this year, the overall level of cash flowing into the hedge fund community is dwindling. The reason is simple: Hedgies are having a rotten sovereign-debt crisis. According to Hedge Fund Research, many funds have failed to protect investors’ capital, losing upwards of -5% this year in a flat-to-slightly down market.
Reports indicate that performance has fluctuated tremendously for 2011. The average fund is down -3.5% YTD. Fear in the markets has led many asset classes to climb and fall almost simultaneously, making it all the more difficult for funds to find uncorrelated returns as well as appropriate ways to hedge positions. In short, traditional hedging techniques are not functioning as well as they have in the past.
Let’s look at the numbers. Hedge Fund Research’s Global Hedge Fund Index is off -8.09% as of Thursday’s close while the so-called “absolute return” index is down -3.45%. And then the long/short “directional index” is off an eye-popping -16.7% year-to-date.
More specific categories are suffering even greater declines. Equity Hedge is off -17.98% and Fundamental Value is down -23.01% through 11/17.
Obviously, there are winners this year as well. With the stock market in the red for the calendar year, short-biased hedge funds have produced solid returns. However, this is a rather skinny category and one that naturally should be doing well in this market.
The WSJ reports that there are some other success stories as well as Red Kite’s specialist commodity Metal and Prospect funds have experienced gains of over 50% from bearish trades on metals such as copper. However, many mainstream funds have fallen well short of expectations. The poster child here is Paulson & Co’s flagship Advantage fund, which is down -33% as of 9/30 due primarily to trades that overestimated the strength of a U.S. recovery.
Remember, hedge funds are supposed to “hedge” downside risk. The original concept behind hedge funds is for managers to hold both long and short positions, thus producing a market-neutral position. The idea is to own longs that will outperform the market indices and sell short stocks that are expected to decline. In other words, it is supposed to be a win-win situation, regardless of market conditions.
However, with correlations among stocks and asset classes relative to the S&P 500 at all-time record highs, almost all investment classes are being affected by the current “risk on/risk off” environment. In other words, the markets all tend to move in the same direction at the same time. Even assets that were once considered non-correlated are now closely correlated to the overall stock market indexes.
As the end of the year grows near; hedge fund managers are fretting over the question of whether or not the weak returns seen in 2011 will translate into mass investor withdrawals.
Some feel that the underperformance of an investment that isn’t supposed to underperform – ever – may cause investors to vote with their feet. For example, a source told HFMWeek that he would be “surprised” if there weren’t net outflows in the fourth quarter.
“I can’t help but think that in the current market environment, there will be outflows. We are in an industry where a high percentage of assets are held by a small number of firms. When the biggest firms start reporting outflows it is a good sign that the industry is losing money…”
At issue is the heightened degree of daily volatility caused by the European debt crisis. European politics and economic concerns have played a decisive role in the sky-high volatility, and surprisingly, managers appear to be ill equipped to respond fast enough to keep up with the fluid sovereign debt crisis. Last month, funds were pummelled by huge daily swings in equity indexes in response to European leaders’ fast-changing plans to combat the crisis.
The WSJ reports that some macros funds continue to maintain a bearish view on Europe. But given the abject failure of CDS to act as a hedge, traders have turned to taking unhedged short positions in liquid markets such as France and Germany while others have worked to eliminate exposure to the euro mess by increasing U.S. Treasury holdings.
Another factor making it difficult for hedge fund managers working the European markets this year is the fact that short-selling has been limited by regulation. For example, in several Eurozone countries, shorting financials is no longer allowed and even owning “naked” credit default swaps (a bet against sovereign debt) has been outlawed.
As a consequence, hedge funds have made a concerted effort to de-risk portfolios by simply selling positions, thereby potentially capping returns – and unfortunately, locking in losses.
In an effort to reduce exposure to stock correlations in a down market, cash levels remain high at slightly more than 20% of the average hedge fund’s assets. Also, hedge funds across the globe have net long positions in gold.
The Wall Street Journal warned that unless performance quickly improves any current inflows trends could be reversed by year-end.
Yet interestingly, according to a survey released last Friday from industry data-tracker Preqin, 80% of shareholders are considering investing with new hedge fund managers, and 38% are planning to increase the amount of their hedge-fund investments over the next year.
Despite managers’ concerns that investors will lose their patience and opt to reallocate away from the hedge fund class entirely, some are hopeful that despite negativity, hedge funds have proven their merit as diversification tools.
Ken Heinz, president of HFR remains optimistic, hopefully saying: “…investors have kept the faith with the industry.”
However, with the stock market indices still down on the year and correlations still pushing all-times, we wouldn’t rule out the possibility that outflows could pick up in a meaningful way.
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