At last, hedge funds able to get back to business

After two tumultuous years, 2010 has been a year in which hedge fund managers concentrated on their funds and their businesses.

Although many hedge fund managers have been forced to cope with turbulent global macroeconomic forces well outside their control in 2010, particularly Europe's worsening sovereign debt problems, the hedge fund industry was not buried by bad news, unlike 2008 and 2009.

“After 2008 and 2009, no news is good news,” said Stephen L. Nesbitt, CEO of specialist alternative investment consultant Cliffwater LLC, Marina del Rey, Calif. “2008 was the year of the disaster, 2009 was the year of recovery and 2010 is the year that managers delivered on their promises,” he said.

Despite uncertainty over the recently disclosed insider trading investigation, 2010 was most notable for its lack of scandal, spectacular hedge fund blowups or horrendous performance.

Instead, new hedge fund launches are on the rise, merger-and-acquisition activity in the hedge fund arena is picking up and institutional investors show little sign of slowing their investment pace.

In fact, in Bank of America Merrill Lynch's most recent institutional investor survey, 55% of respondents said they intend to increase their direct investments in hedge funds over the next one to two years.

Hedge fund managers spent the past year sorting out and shoring up their businesses, said Ron Suber, senior partner and head of global sales and marketing for hedge fund trading and technology provider Merlin Securities LLC, New York.

“In 2010, hedge fund managers surpassed their high-water marks, due to positive performance. They reduced their fixed expenses and attracted new inflows into new strategies, especially into managed accounts,” Mr. Suber said.

Net inflows improved for both hedge funds and funds of funds during the past year. A net $42.3 billion flowed into hedge funds in the first three quarters of 2010, bringing total industry assets to $1.8 trillion as of Sept. 30, up from $1.6 trillion at the end of 2009, according to data from Hedge Fund Research Inc., Chicago.

The positive flows in the first nine months of this year are in marked contrast to 2009, which saw a net outflow for the year of $131 billion, and 2008 with a total net outflow of $154 billion, HFR's research shows.

Hedge funds of funds experienced net inflows in the third quarter of $256 million, compared with net outflows of $13.9 billion in the first half of 2010, $118 billion in all of 2009 and $41 billion in 2008.

“Bottom line, 2010 has been a good year in the sense that hedge fund returns met expectations — in the high single digits — and kept their risk relatively low despite month-to-month volatility. May was the litmus test and hedge funds held up well,” Cliffwater's Mr. Nesbitt said.

Year-to-date Nov. 30, the HFRI Fund Weighted Composite index returned 7.12%, compared with the 7.88% return of the Standard & Poor's 500 stock index and the 8.6% return of the Barclays Capital Government/Credit Bond index, said Kenneth J. Heinz, HFR president, in an interview.

Hedge funds did a good job of protecting on the downside in 2010, including May: The HFRI Fund Weighted Composite index was down 2.89% vs. -7.98% for the S&P 500.

But Mr. Heinz and other sources said hedge fund performance would have been significantly better in some strategies this year if not for the omnipresent impacts of global macroeconomic forces.

“Despite rosier expectations, the macro picture remains bleak in the short run and investment themes remain sensitive to changes in economic policies and sovereign risk,” wrote Aureliano Gentilini in the December edition of the Lipper Hedge Funds Insight Report. Mr. Gentilini, global head of hedge fund research, is based in Lipper Hedge Fund Research's Milan, Italy, office.

“The global macro picture, the outlook and market sentiment appear to plot a scenario not necessarily favorable to equity investment. Similarly to what occurred in May, hedge fund portfolios appear to be exposed to potential risks arising from crowded trades; significant losses might materialize in case of a market reversal,” Mr. Gentilini said in the report.

The impact of macro factors on hedge fund performance has been most acute for long/short equity managers, said consultant James McKee, director of hedge fund research at Callan Associates Inc., San Francisco.

“The big disappointment in 2010 has been in the performance of fundamental stock pickers, i.e., long/short equity managers. The beta of the world has been swamping them. Their alpha generation is dependent on their security selection, and those securities have been getting knocked around by macro factors,” Mr. McKee said in an interview.

“There's been ... universal angst over the macro trade” among hedge fund managers and both institutional and retail hedge fund investors, Mr. McKee said, and that's led to “a strong interest in the use of sector ETFs or macro calls within long/short equity funds. That's their reaction to a market that's been giving them heartburn over the beta ride they're being forced to take.”

Mr. McKee said a move from a bottom-up, fundamental stock-picking strategy by long/short equity managers is cause for concern. “We're not advocating that clients move out of hedge funds, but we're definitely looking for managers that are not adding an element of the macro trade to their investment strategy if it's not appropriate,” he said.

Hedge fund managers that can navigate “increased macro event volatility ... with the tools and the demonstrated ability to use them wisely,” will be a differentiating factor for institutional investors going into 2011, said Bruce McGuire, president of the Connecticut Hedge Fund Association, Farmington, Conn., said in an e-mailed response to questions.

Other sources agreed, adding they are optimistic about hedge funds' prospects in 2011, but few anticipate a banner year in terms of performance unless those macroeconomic factors fade.

“I'm hoping that 2011 will be what I hoped 2010 would be, a year of significant improvement in both performance and net inflows into hedge funds. 2010 ended up being a muted year, one of recovery rather than strong growth,” said consultant Howard B. Eisen, managing director, FletcherBennett Capital LLC, New York.

Cliffwater's Mr. Nesbitt predicts that hedge fund performance in 2011 likely will hover between 7% and 8%, not much better than 2010. Still, hedge fund returns likely will significantly outpace domestic bond returns, which Mr. Nesbitt predicts will range from 3% to 5%. And because they offer downside protection, hedge fund returns also will be an improvement on the 7% return Mr. Nesbitt expects for global equity.

Given low return expectations for traditional asset classes in 2011 and beyond, many institutional investors anxious to meet their investment return assumptions are increasing their hedge fund allocations.

But given the performance differential between hedge funds and funds-of-funds managers — 7.12% for the HFRI Fund Weighted Composite index and 3.04% for the HFRI Fund of Funds Composite index year-to-date Nov. 30 — Mr. Nesbitt forecast that most large institutional investors will move away from a reliance on hedge funds of funds.

The Bank of America Merrill Lynch Institutional Investor survey found only 5% of respondents said they intended to increase hedge fund-of-funds allocations, 23% said they will decrease their allocation and 31% don't intend to make a change.

Consultant Vidak Radonjic, managing partner, The Beryl Consulting Group LLC, Jersey City, N.J., provided his list of 2011 hedge fund strategy predictions by e-mail, including:

• a mild conviction that equity correlation will lessen and “perhaps reverse itself in 2011 as the market conditions start to normalize and reverse to the mean”;

• nimble global macro managers “very well-immersed” in the “euro turmoil” theme should thrive; and

• volatility arbitrage strategies could do well because “global market imbalances have risen” and the U.S. and European authorities are pursuing different strategies to get out of their recessions. The imbalance may cause sudden volatility and the “right vol arb manager who will take advantage of a sudden shift in VIX will be critical to preserve or boost value of any investment portfolio.”

With regard to the Justice Department's insider trading probe (Pensions & Investments, Nov. 29), white-collar crime specialist attorney Richard L. Scheff said his take is that the investigation has found that “rogue activity is going on. Individuals within some companies are being corrupted for money. That's a much different case than a systemic, top-down order from an expert network that directs employees to go out and find people in companies who will provide insider information.”

Mr. Scheff, who is partner and chairman of Montgomery, McCracken, Walker & Rhoads LLP, Philadelphia, said in an interview that institutional investors should be demanding that the hedge funds or funds of funds in which they invest strengthen their compliance processes when it comes to research and information gathering.

Institutional investors “have the power to demand very robust compliance from their hedge fund managers and should expect that to happen,” Mr. Scheff said.