Institutions not fazed by rumors and performance

The institutional investment management community seems relatively unfazed by the hoopla over poor hedge fund performance and rumors of massive redemptions.

For example, just 3% of respondents to an informal poll of 40 large institutional investors said their greatest concern about hedge fund investing was a major catastrophe such as a liquidity crisis. The survey was conducted in mid-May by money manager Strategic Investment Group, Arlington, Va., as part of its annual investment dialogue, a meeting of institutional investors on specific topics.

Recent hedge fund performance has been disappointing: The CSFB/Tremont Hedge Fund index returned -0.93% for the first quarter, -0.11% for the four months through April and -1.04% for the month of April.

Still, hedge fund performance has been a bright spot compared with most other asset classes.

In negative territory for the four months were the Standard & Poor's 500 index (-4%), the Russell 3000 index (-4.33%), the Morgan Stanley Capital International Europe Australasia Far East index (-2.33%), and the J.P. Morgan Non-U.S. Government Bond index (-1.57%). The Citigroup Broad Investment Grade bond index, at 0.89%, was the only benchmark with a positive return.

"There's not a lot of outcry from our client base about hedge fund performance, because all of the asset classes are doing poorly," said Jim McKee, director of hedge fund research at Callan Associates Inc., San Francisco. "Viewed within the context of other asset classes, hedge funds are not causing that much concern."

In spite of negative returns in April and bad hedge fund news in the world press in May, Mr. McKee said his phone isn't ringing off the hook. "The fact that I am not getting a lot of calls from clients tells me that they are behaving as long-term investors."

"Institutional clients are not really going to react to monthly or quarterly returns."

Mr. McKee said most of the concern in the institutional marketplace now is over hedge funds of funds that use a lot of leverage or rely heavily on structured products. But most of these are European and not used much by institutional investors. He added that most redemptions seem to be by taxable, high-net-worth investors leaving troubled hedge funds and funds of funds that are invested in them.

Officials at hedge fund-of-funds companies are sitting tight, waiting out a market that continues to be plagued by fairly low volatility, widening credit spreads and isolated market dislocations, most recently in the credit derivatives and convertible arbitrage areas.

Mazen Jabban, chief executive officer of Focus Investment Group Ltd., New York, said portfolio managers there aren't doing "anything that we do not normally do (in) a given month." Focus manages about $1 billion in hedge funds of funds.

"The best thing you can do now is to stay on the sidelines and review your managers, making sure they are doing what they are supposed to do," Mr. Jabban said.

Barry Colvin, president of Rye, N.Y., hedge fund-of-funds manager Tremont Capital Management Inc., agreed. "The message is: Don't go crazy on top-down change right now. Don't tinker. It's not one of those times when we are overweighting one strategy or another because there is little value to be found anywhere. You've got to choose your managers well and let them to do their jobs." Tremont has about $10 billion in hedge funds of funds.

Mr. Colvin noted high correlations among securities and high correlations between strategies of hedge fund and traditional managers is making it even harder for hedge funds to make money.

"Hedge funds have lulls in opportunity on a cyclical basis. There are times when you might tilt your portfolio strategically from a top-down perspective, but this is not one of those periods. We are all about bottom-up right now," he said.

Institutional investors with longtime investments in hedge funds and funds of funds "have been through droughts and a long education process. They are not overly concerned about current performance," said Laurie Bonello, principal-alternative investments and head of hedge funds of funds at Strategic Investment Group. Ms. Bonello oversees management of $1 billion in hedge fund-of-funds assets.

Ms. Bonello added that newer hedge fund investors are asking more questions but staying put. "With tight spreads and compressed valuations, where else would you want to go? Hedge funds remain attractive relative to other asset classes," she said.

Performance data from Callan's hedge fund-of-funds database group supports the notion that hedge funds of funds are protecting their institutional clients on the downside. Most of the 200 or so large institutional hedge fund-of-funds managers included in the Callan database showed positive returns (net of fees) in the first quarter, with the median return at 0.99%. The 10th percentile in Callan's hedge fund-of-funds universe returned 2.29%, and the 75th returned -0.15%. The S&P 500 returned -2.15% for the quarter.

Returns of the Callan hedge fund-of-funds group consistently outperformed the S&P 500 over longer time periods: 7.66% for the year ended March 31; 9.76% for five years; and 13.7% for 10 years. S&P 500 returns over the same time periods were 6.69%, -3.16% and 10.79%, respectively. Multiyear returns are annualized.