Hedge funds pass the test

Funds of hedge funds have had their metal tested in recent months and investors eyeing up these funds ahead of their entry into the retail mainstream next year will be eager to see how they fared in recent stock market routs.

The good news is many funds have shown remarkable resilience overall this year, producing positive returns despite a couple of sizeable stock market corrections.

The bad news is the latest bout of equity market falls in early August, which wiped hundreds of points off world stockmarket indices, appears to have caught most funds of hedge funds off guard. After bearing up well during a choppy July – the average London-listed fund of hedge funds rose 1.41% despite a 3.4% drop in the FTSE All Share, according to research by Dresdner Kleinwort – most listed funds went on to lose money in the first two weeks of August. Dispersion among open-ended funds was even higher and those with heavy quant allocations fell more than 4%.

Experts believe this is because certain quantitative strategies used by some underlying single strategy funds did not work well due to an unusually high correlation across asset classes.

Pryesh Emrith, hedge fund and structured products analyst at Charles Stanley, says the correlated nature of the sell off in August meant that even funds employing the most liquid strategies suffered.

“Even fund of funds which had made money by having high allocations to managers who benefited from the sub-prime sell off in July lost money [in August],” he says.

David Smith, chief investment officer of GAM Multi-Manager and manager of the GAM Diversity range of funds of hedge funds, believes increased correlation between hedge fund strategies led many quantitative-based single strategy funds to move into the same stocks that fundamental long/short equity investors focus on. This meant long and short portfolio positions became heavily crowded across both statistical arbitrage and equity long/short managers with a value bias, he says.

“Unfortunately for these hedge funds, the need to de-leverage occurred at the time of year when market volumes were seasonally thin,” Smith says. “Thus large statistical arbitrage hedge funds were liquidating positions in order to take down their fund leverage. As they started to do so their very own volatility indicators caused them to sell even more and it became an increasingly vicious circle.”

Smith says the result of this was exaggerated portfolio losses. Some statistical arbitrage managers were forced to draw down anywhere between 5% and 10% on a single day. Smith’s multi-strategy GAM Diversity fund lost just over 5% between June 30th and August 30th, according to figures from Trustnet, despite having generated positive returns in every discreet 12 month period for the last 10 years (to June 30, 2007). “This type of volatility has never been experienced in the history of hedge funds,” Smith says.

Despite the recent upset, Emrith points out that fund of hedge funds losses were less severe than those in other asset classes like equities. He says assuming recent asset correlation was a one off funds of hedge funds remain a good investment option for those seeking portfolio diversification.

Indeed, diversification and a lack of correlation with other asset classes are likely to be big selling points for fund houses when the Financial Services Authority (FSA) brings funds of alternative investments (FAIFs) under its wing, most likely next year.

But issues remain which may deter less sophisticated investors such as their lack of transparency and the complicated techniques employed by underlying hedge funds.

Robin Gordon-Walker, spokesman at the FSA, says the regulator imposes transparency requirements on authorised schemes which will mean FAIFs marketed to retail investors will need to publish half yearly and annual reports for unit holders.

However, he adds that as with long only investments an element of opacity is likely to remain. “We are not sure that FAIF investors need to know what underlying funds the manager is investing in any more than, for example, he needs to know what shares a more traditional fund is investing in,” he says.

1 September 2007