Hedge funds to see brighter opportunities in 2013

But lower revenues might result as institutional investors successfully push fees down

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Tempering: Kenneth J. Heinz doesn't foresee a spectacular year, thanks to lingering economic and political woes.

The new year is expected to be one of changes that will provide hedge fund managers with opportunity for better performance and new inflows from fresh sources.

But lower revenues might result as institutional investors successfully push fees down and hedge fund managers offer low-cost versions of their funds to attract defined contribution and retail investors.

Hedge fund managers and industry observers didn't say it would be easy, but they did forecast that hedge fund strategies overall likely will produce better returns this year than they did in 2012 when the HFR Hedge Fund Weighted Composite index produced a 3.08% return year-to-date Nov. 30.

Sources were not willing to predict where hedge fund strategy and major market indexes would end up at the end of December.

“The trees aren't going to grow to the sky” this year, said Kenneth J. Heinz, given “the incredible global environment” caused by the European sovereign debt and banking crisis, uncertain U.S. politics and unrest in the Middle East. Mr. Heinz is president of Hedge Fund Research Inc., Chicago, the manager of the HFR index family.

“Because of all the uncertainty in the world right now, investor risk tolerance is very low, including hedge fund portfolio managers, but even if all the uncertainties aren't resolved early this year, there will be more clarity about what is going to happen globally. That will encourage many hedge fund managers to be less risk averse than they have been ...,” Mr. Heinz said.

On the sidelines

At the moment, hedge fund managers are — to some extent — sitting on the sidelines, poised for that flash of clarity so they can jump into what Capstone Investment Advisors LLC's Paul Britton said will be “huge opportunities as lots of risk capital that's been held on the sidelines floods the market. I don't care if investors are coming in to buy or sell, but all of that capital moving around will create price dislocations.”

While he waits for resolution, Mr. Britton, Capstone's CEO and founder, said he is somewhat flummoxed by market signals. “We're not macro guys, but we're concerned and frustrated by trying to put a risk factor on the behavior of Washington, D.C., politicians. Our model needs to assess the impact of increased market volatility caused by politicians' inaction and I am frustrated that I can't quantify this,” he said.

“It's too dangerous to assign a risk factor to Washington politics, but we will be ready to deploy capital as soon the signal comes. We have to have employees here in the office all the time, day and night, in order to be ready in an instant to trade,” Mr. Britton said.

New York-based Capstone has closed its flagship volatility strategy to new investment at $1.9 billion. Investors already have committed between $650 million and $750 million to the strategy when it briefly reopens in the first quarter.

Mr. Heinz predicted that relative value fixed-income strategies will continue to produce positive returns in 2013, although they will not continue to be the one of the leading performers as they were in 2012.

Instead, equity hedge strategies, garden-variety long/short equity approaches, likely will pick up steam, said Mr. Heinz.

That's because after midsummer 2012, global equity markets began to show more dispersion and less correlated returns, which gave fundamental stock pickers a much better shot at making money on their bets, said Todd Builione, president of Highbridge Capital Management LLC, New York, and CEO of its hedge fund business.

Mr. Builione forecast that global markets in 2013 will continue to focus on stock fundamentals, giving long/short hedge fund managers a chance to continue their performance streak.

Highbridge's investment team also sees significant investment opportunities in European convertible bonds as well as in merger arbitrage, partly because “depending on how the strategy is implemented, it can be very complementary ... it has a low correlation to our existing strategies and exhibits low market directionality,” said Mr. Builione.

“Companies are flush with cash right now but they are not moving to make acquisitions. Once the fiscal cliff is resolved, however, it's likely we'll see an explosion of merger activity. We need to be ready to move fast when that happens,” Mr. Builione said.

Highbridge manages $29 billion in single and multistrategy hedge funds.

Long/short equity also is on the list of priority strategies this year “for the first time in a few years because equity correlations are starting to break down,” for the industry's largest hedge funds-of-funds and solutions manager, Blackstone Alternative Asset Management, said J. Tomilson Hill, president and CEO of the New York-based firm.

Quantitative approaches, non-performing mortgages and loans, commodities and emerging market credit also are in BAAM's sights this year.

Commodities are of particular interest, Mr. Hill said, precisely because of high uncertainty around the globe. “Volatility is your friend when it comes to commodities,” he said, noting Blackstone has “significant” exposure to commodities in hedge fund long/short and relative value strategies, as well as in long-only funds.

BAAM manages $46 billion for institutional investors, $17 billion of which is in traditional hedge funds-of-funds vehicles.

Regardless of returns in 2013, hedge fund and funds-of-funds managers will continue to be pressured to lower their fees well below the old standard 2% management fee and 20% performance fee.

“Fees have been a story since 2008,” said Jim Vos, CEO, principal and head of research at hedge fund consultant Aksia LLC, but he stressed “the dam really broke wide open in the summer of 2012. This is really big. It's not just cocktail conversation any more.”

“Rampant fee negotiation is happening everywhere. Hedge fund managers don't like it at all. Fees are the focus of every meeting they have with institutional investors. And managers are being forced to make pricing concessions because they want to keep their institutional clients even when performance is not meeting expectations,” Mr. Vos said.

'Fee-light' vehicles

Large hedge fund managers might resist lowering fees on their flagship hedge fund vehicles, but they are increasingly offering these strategies in “fee-light” vehicles, primarily low-cost mutual funds in the U.S. and Canada, and UCITs funds in the U.K., said Daniel Celeghin, a partner at management consultant Casey, Quirk & Associates LLC in Darien, Conn.

For many hedge fund companies, the one reliable place they likely will see growth is lower-fee versions of their strategies designed to attract defined contribution plan sponsors and the broader market of affluent investors, Mr. Celeghin said.

But distribution systems for mutual funds are very different from the kind of intensive institutional marketing process hedge fund companies have become used to, Mr. Celeghin said.

Some firms are finding partners with distribution capabilities or are building internal distribution networks, but without that infrastructure, attracting tens of thousands of retail investors to their new mutual funds will be difficult, Mr. Celeghin stressed.

This article originally appeared in the January 7, 2013 print issue as, "Opportunities brighter, but revenues could take a hit".