NEW YORK - Hedge fund advocates are touting 2001 as another banner year for absolute return strategies: Preliminary numbers show nearly $90 billion flowed into hedge funds, and hedge fund strategies overall outperformed all the major equity indexes for the year.
But the hedge fund industry faces a number of challenges in 2002. Will there be enough good managers with enough capacity for new assets to handle the expected demand? Can hedge funds significantly outperform equities if stocks recover? What effect will the Argentine debt default have on emerging markets strategies? And which hedge fund strategies are poised to outperform this year?
Despite the questions, Virginia Reynolds Parker, founder and president of Parker Global Strategies, New York, a hedge fund manager of managers, expects hedge fund assets to grow by 20% by year's end.
"Hedge funds will continue to be the bright spot in the asset management industry," Ms. Parker said. "A desire for alternative investments with positive returns, demand for risk management and increasing institutional comfort with hedge fund investments should lead to continued growth for the hedge fund industry in 2002."
Ms. Parker said arbitrage strategies, which seek to take advantage of price discrepancies in securities traded in two or more markets, should perform best in 2002. "Steep yield curves and historically low global interest rates should lead to extremely favorable returns for convertible arbitrage, fixed-income arbitrage and yield-curve arbitrage strategies in 2002," she said.
Big jump
Hedge fund strategies saw their biggest single-year jump in assets in 2001, with some $86 billion flowing in, according to The Hennessee Group LLC, New York. In 2000, investors poured $75 billion into hedge fund strategies. When growth due to performance is factored in, hedge fund assets grew to $508 billion at the end of 2001, up from $407 billion at the end of 2000, according to The Hennessee Group.
Some of that money no doubt came from investors seeking some kind of positive return, even if only a few hundred basis points. The 500-odd managers comprising the Hennessee Hedge Fund index outperformed the broader equity indexes like the Standard & Poor's 500 stock index, the Nasdaq composite index and the Russell 2000 stock index in February, March, April, July, August and September last year, according to The Hennessee Group. For the 12 months ended Dec. 31, hedge fund strategies returned nearly 4%, compared with -21% for the Nasdaq, -13% for the S&P 500 and 1% for the Russell 2000.
Not surprisingly, strategies that took advantage of volatility, like convertible arbitrage, and falling stock prices, like short-biased strategies, recorded the best returns in 2001. Convertible arbitrage returned 15% year-to-date as of Dec. 31, according to The Hennessee Group. Short-biased managers returned 13%.
The Credit Suisse First Boston/Tremont Hedge Fund index was up 4.4% for 2001. Convertible arbitrage strategies were the second-best performers, recording a 15% return in 2001. However short-biased managers in the CSFB/Tremont index returned -4% for the year.
U.S. hedge fund managers in the Nashville, Tenn.-based Van Hedge Fund Advisors International Inc., hedge fund index returned 5.6% through Dec. 31, 2001. Short sellers returned 8.2% for the year. The Van index does not break out convertible arbitrage as a separate strategy.
At LJH Global Investments, Naples, Fla., convertible arbitrage strategies had returned 13% through Dec. 31, according to the firm's hedge fund index. Short-only strategies had returned 6% through the same period.
Strategic shifts
Jeff Major, vice president of research at LJH Global Investments, Naples, Fla., said some volatility-based strategies may not fare as well in 2002. More volatile technology stocks are falling out of major equity indexes and are being replaced by more stable, cyclical stocks, he said. Also, zero-coupon bonds are becoming more popular in convertible issuances, reducing volatility in that strategy; and the introduction of the euro and coordination of global interest rate policies also will lessen volatility.
Mr. Major suggested avoiding long-short equity or heavily directional strategies. Instead, LJH is looking at strategies such as distressed debt; fixed-income arbitrage; emerging markets, to take advantage of strong credit markets; what interest rate volatility there will be; and strengthening Asian markets.
Bruce H. Lipnick, founder, president and chief executive officer of Asset Alliance Corp., a New York-based holding company for hedge funds, said he thinks equity and fixed-income volatility will be high this year, and he predicts emerging markets, long-short equity, fixed-income and convertible arbitrage strategies will benefit.
At Mezzacappa Management LLC, a fund of funds specializing in finding long-short managers, founder Damon Mezzacappa said long-short equity is the place to be in 2002.
"We feel it's the strategy that, over any reasonable period of time, will help us achieve our objective of above-average returns with below-average risk," he said.
The New York-based company has just less than $1 billion under management.
Mr. Mezzacappa sees 2002 as a good environment for stock pickers, with plenty of month-to-month volatility but no big gains or losses for the major indexes in the end.
Parker Global Strategies' Ms. Parker said fixed-income arbitrage and long-short equity strategies look interesting: "We anticipate there will be some pretty good volatility in the markets over the next year. For those managers who are adept with their stock-picking skills, there should be some good opportunities."
Abundance problem
But finding the right strategies will be only half the battle in 2002. Growing institutional interest in hedge funds means more assets flowing in, which means more good managers will close their funds to avoid getting too big.
On the plus side, those closures create opportunities for new managers. On the down side, only about 10% of startup hedge funds stay in business even three years, Ms. Parker said. In other words, the odds are against picking a great hedge fund manager from among the new crop opening their doors.
Capacity will be the top issue for the hedge fund industry in 2002, Ms. Parker predicted. "It can be hard to find managers with long track records," she said.
The capacity issue will manifest itself in a couple of ways, said LJH's Mr. Major. Hedge fund fees will rise as top managers close to new assets and lock in high fees. And more top mutual fund and portfolio managers will set out to open their own hedge funds, which in turn will spur established managers and mutual fund companies to consider offering their own hedge fund products.
Mr. Mezzacappa sees the capacity issue in a somewhat different light. He predicts there will be plenty of managers out there to handle incoming assets; he just thinks most of them won't be very talented.
Due diligence vital
A report from hedge fund information provider Infovest21 LLC, New York, warns investors that conducting due diligence before investing in hedge funds is important because of what it calls the "large quality variation among available products."
The report also discusses growing institutional interest in hedge funds and cites 86 institutions that have made allocations to hedge funds or are considering doing so. In 2001, according to Infovest21, those institutions included the $14.8 billion Illinois Municipal Retirement Fund, Oak Brook, which allocated $225 million to three Chicago-based funds of hedge funds - Harris Associates LP, Grosvenor Capital Management LP and Mesirow Advanced Strategies Inc. - and the $27 billion Pennsylvania State Employees' Retirement System, Harrisburg, which committed $200 million to a fund of funds run by Blackstone Alternative Asset Management, New York.
College and university endowments are among the biggest users of hedge funds, and their interest in the strategy appears to be growing, according to a report from the National Association of College and University Business Officers, Washington.
For the fiscal year ended June 30, the average endowment had an equal-weighted mean hedge fund allocation of 2.9%, up almost a full percentage point from the 2.1% reported for the fiscal year ended June 30, 2000.
