Reversal of fortune

Many hedge fund strategies reach positive territory in Q1

Updated with correction on June 1

In a widespread reversal of fortune, many hedge fund strategies returned to modest positive performance in the first quarter of 2009.

According to Morningstar Inc., average performance in the first three months of the year was positive for 68% or 15 of the 22 hedge fund strategies within its hedge fund database. Morningstar data, calculated exclusively for Pensions & Investments, is based on the funds managing more than $100 million from among the 8,000 hedge funds that report data to the fund researcher.

That’s a big improvement over the fourth quarter, when 77%, or 17 of Morningstar's 22 hedge fund style classes, turned in deeply negative average returns.

The average return in the first quarter for all hedge funds in P&I's customized universe was 0.42%.

Hedge funds smartly outperformed traditional market indexes in the first quarter, with the average performance of every Morningstar style category beating the -11.01% return of the Standard & Poor's 500 index and the -12.5% performance of the Morgan Stanley (MS) Capital International World index. Only seven style categories — all in negative territory — failed to beat the 0.12% performance of the Barclays Capital Aggregate Bond index for the three months.

Convertible arb stages a comeback

With average performance of 12.45% in the first quarter, convertible arbitrage strategies outpaced all other Morningstar style categories and represented a big comeback for the style, which ranked 16th of 22 in the fourth quarter with an average return of -10.83%.

Chicago-based Morningstar hedge fund analyst Nadia Papagiannis attributed the strategy's turnaround to events in the fourth quarter. She said hedge funds, the biggest holders of convertible bonds, were forced by high redemption requests for Dec. 31 distributions to sell off their securities en masse in the last three months of 2008, which drove prices down and widened spreads. But when spreads tightened last quarter, especially in January and March, convertible arb specialists who held on to their securities made big profits, Ms. Papagiannis said.

The corporate actions style was even lower on Morningstar's average performance ladder, ranking at 20, with average performance of -12.99% in the fourth quarter. But it climbed to the second rung of first-quarter performance with an average 3.28%.

Ms. Papagiannis said that after the fourth quarter, which was characterized by many broken merger deals and dried up financing sources, "some life returned to the space, led by bankruptcy- or government-led deals, especially distressed deals. While the total deal volume still was down compared to the same time in the previous year, it was much improved over what we saw in the fourth quarter."

The 2.93% average return of multistrategy hedge fund managers in Morningstar's universe was good enough to make the category the third best performer in the quarter. Ms. Papagiannis said much of the improvement came from the high exposure managers had to convertible securities.

A 2008 darling drops to the bottom of the pack

One darling of hedge fund industry in 2008 — global trend strategies — fell to the bottom of the performance ranking as markets improved in 2009. Global trend managers, who follow strict trading processes that focus on global trends, were the second-worst performing of Morningstar hedge fund style classifications with average performance of -2.85% in the first quarter.

"When markets whipsaw, it really impacts those quantitatively oriented trend funds badly," Ms. Papagiannis said. She said price gyrations in commodities, especially oil, gold and the U.S. dollar, left trend managers without a trend to follow. Global non-trend strategists who are less quantitative and use more fundamental analysis in securities selection did a fairly good job of neutralizing market impact in the first quarter, with average performance of -0.05%, Ms. Papagiannis said.

Short equity managers, who did fairly well in the second half of 2008 and were the second best-performing style category in the fourth quarter with average performance of 4.4% were the victims of first-quarter markets, ending up in the 15th spot with flat performance of 0.13%.

Cautious funds-of-funds managers miss rallies

Hedge funds-of-funds managers "remained very cautious about market exposure after high redemptions in the fourth quarter. Many don’t want to do anything that will jeopardize their ability to maintain their businesses and had little market exposure, which meant they were not able to take advantage of the market rallies last quarter," Ms. Papagiannis said. She noted that the hedge fund of funds non-directional style category did fairly well with average performance of 2.54% in the three-months ended March 31 because managers did not take directional bets on market performance.

Except for the fund of funds debt category, which ranked as the worst average performer in the quarter with -3.23%, the rest of Morningstar's style specific hedge fund categories were smack in the middle of the rankings with positive — although essentially flat — average performance.

Every one of the 25 top-performing hedge funds in the Morningstar universe of funds managing more than $100 million was new to the ranking in the first quarter. There was much less style correlation among the 25 best performers in the first quarter, with a bias toward arbitrage strategies with 10 of the top funds falling into the convertible, equity or debt arbitrage classifications. By comparison, 18 of the 25 best performing hedge funds in the fourth quarter were global trend followers.

Four of the five best performers were arbitrage managers, led by Barnegat Fund Ltd., Series B, with a 38.3% return in the first quarter. The debt arbitrage fund is managed by founder Bob Treue. The UG Greater China Multi-Strategy Fund, a developed Asia equity fund, managed by UG Investment Advisers Ltd., Singapore, was the second with 32.27%, followed by the Investcorp Silverback Arbitrage Fund in third with 28.8%. Investcorp International Inc., New York, manages the equity arbitrage fund.

Another equity arbitrage fund, the Canyon Capital Arbitrage Fund Ltd. was in fourth place with 28.04% and is managed by Canyon Capital Advisors LLC, Los Angeles. Waterstone Capital Management LP, Minneapolis, manages the No. 5 fund, the Waterstone Market Neutral Master Ltd., a convertible arbitrage fund, which turned in 22.86%.