Little liquidity, lots of uncertainty sank hedge funds in the first quarter

Economic uncertainty and acute liquidity problems battered most hedge fund strategies in the first quarter of 2008, with the average return for all funds sinking to -2.99% from 1.64% in the fourth quarter.

Performance numbers for hedge funds managing at least $100 million for the three months ended March 31 were almost uniformly negative across all strategies, according to data from Morningstar Inc.’s hedge fund database, run especially for Pensions & Investments.

Only four of 17 Morningstar hedge fund categories produced positive average returns in the first quarter, led by two bright spots. Hedge funds in the short equity fund category averaged 13.02% followed by global trend funds, which produced an average return of 11.33%. Global non-trend funds averaged a 1.69% return while equity arbitrage funds remained barely positive at 0.33% for the quarter.

Data from Chicago-based Morningstar charted the continued downward spiral of hedge funds that invest in emerging markets equity, which came in at rock bottom with an average return of -8.76% in the first quarter, down from -4.3% in the fourth quarter. Funds in Morningstar’s developed Asia equity strategy also continued to plummet, with an average return in the first quarter of -5.28%, compared with -1.28% in the three months ended Dec. 31.

Hedge funds of funds were not immune to the performance problems of the underlying funds in their portfolios, but the average return of -3.01% placed them roughly in the middle of the ranks of Morningstar’s strategy categories.

Although most hedge fund strategies landed in negative territory in the first quarter, the category averages all beat the -9.9% return of the Standard & Poor’s 500 index and the -9.5% return of the Morgan Stanley Capital International Europe Australasia Far East index. The 2.2% return of the Lehman Brothers Aggregate Bond index beat the average returns of 15 of Morningstar’s 17 hedge fund categories.

The problem for hedge fund managers was largely systemic risk that spilled over from credit-related securities to contaminate not only U.S. stocks, but also global equities and many other securities, said Nadia Van Dalen, a Morningstar hedge fund analyst.

“Lack of liquidity and economic uncertainty negatively impacted almost all hedge funds. The liquidity crisis that started in the summer of 2007 spilled over into 2008, punishing the markets and hedge funds’ portfolios,” Ms. Van Dalen said.

Ms. Van Dalen pointed to global trend funds, which are statistically driven and not reliant on fundamentals, as the real winners among hedge funds in the first quarter. She noted that many statistically driven funds that invest and trade based on price trends and were big users of commodity futures strongly benefited from “unprecedented flow into commodity futures. All the money pouring into commodity futures really drove prices up.”

Global non-trend funds also held their own in the first quarter, Ms. Van Dalen said, because while they eschew a strict systematic approach, their managers tend to be very opportunistic and benefited from the depreciation of the U.S. dollar against other currencies as well as from the run-up in the price of commodity futures.

Ms. Van Dalen also noted that while the average return of distressed securities hedge funds remained down in the first quarter, at -3.01%, these funds are poised for a big comeback. “With distressed securities, there’s always a timing issue. These managers have to wait for defaults and bankruptcies to start happening, but when they do, these funds will profit. It’s just a matter of time,” Ms. Van Dalen said. She declined to offer a forecast for the current or coming quarters.

The 25 best-performing hedge funds managing at least $100 million in the first quarter were — predictably — dominated by global trend funds. In all, 15 hedge funds in the global trend category appeared in Morningstar’s top 25 ranking, led by the Mulvaney Global Markets Fund Ltd, managed by Mulvaney Capital Management Ltd., London, with a 44.28% return, followed by JWH Global Analytics, managed by John W. Henry & Co. Inc., Boca Raton, Fla., 31.15%and Quickpool LP, managed by Quicksilver Trading Inc., Santa Barbara, Calif., 27.68%. The Pivot Global Value Fund, a global equity fund managed by Pivot Capital Management Ltd., London, was the fourth best performer in Morningstar’s universe with a 23.16% return for the quarter, while another global trend fund — the AIS MAAP Leverage 2x – 4x Inc., managed by AIS Futures Management LLC, Wilton, Conn., grabbed the fifth spot with a 21.85%.

Contact Christine Williamson at [email protected]