What’s hot and what’s not in hedge funds

The story illustrates that a talented and nimble manager can keep a step ahead of the market. Investors insist these individuals can still be found, but there is little sign the average hedge fund manager showed such skill in 2006. The average long/short equity fund failed to get out of the market before it fell in May and then missed out on the bounce. The average global macro fund mistimed rises in interest rates and underestimated the fall in the dollar.

That said, the average hedge fund was up between 10% and 11% for the first 11 months, according to a variety of data providers. Hennessee said funds in its database were up 10.06% while HedgeFundNet reported 10.65% and the Barclay Group 10.75%. Managers said, barring accidents, they expected the hedge fund indices to finish the year in double digits.

It would be the best performance for three years – the indices struggled to reach 8% in 2004 and last year – but it would be lower than the main equity indices, with the S&P 500 up 14.2% for the first 11 months.

Money has continued to pour into hedge funds. Estimates of the industry’s total assets under management at the start of the year ranged from $1 trillion (€760bn) to $1.5 trillion, which by the end of September had grown to between $1.3 trillion and $2 trillion.

The largest strategy continues to be long/short equity, which can take negative or positive positions on stocks its managers pick out. It accounts for 28% of all hedge fund assets, according to data provider Hedge Fund Research, and its returns strongly influence whether hedge funds are having a good or bad year.

Long/short equity managers are slightly ahead of the average hedge fund, with a return of 10.62% for the first 11 months, according to Hennessee. But on average they lost about 3% of their value between May and July when the stock market fell, then failed to take full advantage of the subsequent upturn.

Equity managers struggled with the lack of a clear trend, according to a spokesman for Forsyth Partners, a fund of hedge funds manager. He said: “Uncertainty over direction left many unable to call the market and they therefore assumed a defensive bias, missing out on the gradual recovery from May and June.”

Those managers that actively engage with companies’ management have been making their presence felt. Centaurus and Paulson upset Dutch trade unions and at least one government minister with their call for a demerger of Stork, a Netherlands engineering firm, even though 86.5% of shareholder votes were cast in favour of the hedge funds’ plans in October. Performance indices for these more activist managers are not available but anecdotal evidence suggests many have generated returns of more than 20%.

Fund of hedge fund managers said they did not expect long/short equity managers to beat the market during a bull run and that the strength of the strategy only appeared during a bear market. The positive performance of long/short equity after the tech bubble burst whet institutional investors’ appetite for hedge funds five years ago. But the failure of the average long/short equity manager to avoid losses when the stock market dipped this year was a disappointment and enthusiasm for the strategy has cooled.

More investors plan to reduce their exposure to the strategy than plan to increase it, according to a quarterly survey of investors conducted by Tara Capital, a Swiss investment research and advisory firm.

Global macro, which capitalises on changes in the global macroeconomic environment and trades in all asset classes, started the year as the most popular strategy, according to Tara Capital, with 61% of investors saying they planned to invest more in it and none saying they would reduce exposure.

But global macro managers had a miserable year, up just 2.22% for the first 11 months, according to Hennessee – less than the return on cash deposits. The misery was epitomised at Brummer & Partners, a Swedish hedge fund manager that wound down its award-winning $1bn global macro fund, Latitude, after losses topped 30%. It had been sure interest rates would fall in the US and UK and lost 6.8% when the Bank of England raised its rate in August.

Vega Asset Management Partners, a Spanish firm that two years ago was the world’s largest hedge fund manager, lost 11.8% of its Select Opportunities global macro fund in a week after betting on falls in US, European and Japanese bonds and that the Japanese yen would appreciate against the euro. The firm continues to run the fund, although with substantially reduced assets.

A spokesman for fund of hedge funds manager EIM said: “Macro managers suffered because of their interest rate strategies. No big trends emerged in currency markets and volatility remained low, which negatively affected managers. Low exposure to equity markets after June penalised managers that did not capture the strong rally initiated in August. It was only in September that managers started to increase their risk levels in that segment again, which proved too late.”

EIM said commodities trading advisers, a group of global macro managers that rely entirely on systems, struggled to cope with sudden reversals in trends.

The disappointment took its toll on global macro’s popularity, with only 20% of investors telling Tara Capital last month they would increase their exposure to it and 13% saying they planned reductions.

Investors plan to invest more in hedge funds but, in search of the talented and nimble manager, are focusing increasingly on less mainstream strategies.

Five best strategies

Emerging markets: 15.09%

Funds face legal and liquidity difficulties shorting shares and have derived much of their return from positive returns in the markets where they invest.

Merger arbitrage: 12.61%

Record year for mergers and acquisitions gave managers plenty of opportunities. Many managers have branched out into the related area of event-driven investing.

Distressed debt: 11.94%

Debt defaults may be at record lows but what opportunities were there proved lucrative. Debt for equity swaps may turn distressed debt managers into equity shareholders and the line between them and buyout firms has become blurred.

Event-driven: 11.55%

Funds gained from rising equity markets and buoyant levels of corporate activity. The strategy performs best when companies follow through with the plans they announce and has

benefited from strong corporate confidence. One of the largest hedge fund strategies with about 13% of the industry’s total assets.

Convertible arbitrage: 9.83%

Rebounded after two difficult years with managers benefiting from increased issuance of convertible bonds and less competition. More than half the investors Tara Capital surveyed said they would be increasing their allocations to convertible arbitrage, a reversal of the position at the start of the year.

• *Market share figures and all performance figures from Hedge Fund Research for first 10 months. Investors’ intentions from Tara Capital

Five worst strategies

Short-selling: -2.02%

One of the smallest strategies with less than 0.5% of total assets faces an uphill struggle whenever the market rises. Charles Gradante, managing principal of Hennessee, said competition had grown: “Private equity firms have been acquiring short positions and the continued growth of hedge funds means managers are having to put more capital to work in short portfolios. This has caused overcrowding and managers have to invest more time to find good opportunities.”

Global macro: 4.4%

Volatility in, and correlation between, equity, bond, currency and commodity markets battered global macro funds. The managers that did best were exposed to rising equity markets.

Diversified fixed income: 5.72%

Managers struggled with a lack of volatility and the best performers did well by identifying short-term directional opportunities. Multi-strategy managers have reduced their exposure to fixed income.

Equity market neutral: 5.84%

Managers often aim to deliver low volatility rather than high returns and investors recognise this. Equity market neutral has remained a consistently popular strategy, with 40% of investors saying they plan to increase their exposure to it and only 7% planning a reduction.

Fixed income arbitrage: 6.05%

Managers found few opportunities, especially in the largest economies, according to fund of hedge funds manager Forsyth, which considered the sector’s performance to be poor this year.

• *Market share figures and all performance figures from Hedge Fund Research for first 10 months. Investors’ intentions from Tara Capital