2005 outlook

2005 outlook

Originally published in the January 2005 issue

Charles Beazley – Gartmore

I see this year as somewhat reflective of the last six to 12 months. In the equity and bond markets I don't see any major inflection points in the near term. On the demand side, particularly with long/short strategies, the market has been emphasising non-directional, risk-adjusted returns and we expect it to continue to do that. People are comfortable with the return they're getting, but would like to see more emphasis on the risk side.

Event-driven is getting more interesting as a strategy as corporate balance sheets start to look more healthy. I also think the credit story has not fully played out yet. We expect to see an enormous demand for the best credit managers in this industry in 2005. On the other hand, convertible arbitrage is likely to do much less well, as there is no obvious sign of significant new issuance.

Regulatory matters, and especially compliance and risk management issues are going to become very real challenges for hedge fund managers to deal with this year. They will become vitally important areas for companies that aspire to chase the institutional money interested in this market. Institutional investors know single managers can do a good job in the operational risk area, but say the vast majority of them have not properly staffed up in this area yet.

If you think about it, 77% of managers in this market have less that $100 million under management. To break even you need to have $75 million in an average year, and last year was by no means an average year. Before you even factor in the additional operational costs they will be presented with, I think a lot of single managers could go under in 2005. A lot of the new asset flow will be into the bigger, more established players.

As for new strategies, a lot of what we as an industry are doing is merging risk management and capital markets skill sets, to give investors the best opportunities the experiments of these two groups produce. I think we'll continue to see people looking around the market for new strategies this year, but it is difficult to predict precisely which ones will find favour.

Overall, I think the hedge fund industry is going to have a good year.


Philippe Bonnefoy – COMAS

Momentum and assets are continuing to build in the hedge fund industry, especially as the emphasis continues to shift away from private clients towards institutions. The challenge for hedge funds this year will be to provide high single digit returns, or low double-digit, to justify their fees and lack of transparency.

It will be a tougher year for fixed income as bond yields will increase. Bond investors will have a tough time. We're going to see a deflationary service sector, but the manufacturing equation will likely come through from a world economic perspective. We've seen a possible peak in the earnings cycle, with GDP looking good in the US, but not great in Europe. Corporate balance sheets, however, look the healthiest they've been in the last few years.

You could see reasonably good performance from GDP growth in the Asian world, but it's not currently a developed market for hedge funds in Asia.

Emerging markets will become more of a rifle-shot than shotgun approach. I'm benignly optimistic about the asset class as a whole. Sovereign spreads are currently at unsustainable levels, but we have had a fantastic environment. Everything's been going right for them. From now on it becomes a bit tougher, it now becomes a bit more focused on a country-by-country basis. Individual government policy will become more important.

On individual strategies, look for single digit returns from US distressed debt, better numbers on European and Asian. We'll see reasonably good returns from relative value, and credit arbitrage should see another good year of solid returns.

Two continuing innovative trends from 2004 will be commodity arbitrage and commodity relative value trading, which continue to do well. Structured credit strategies will get more interesting as they become more efficient.

With an indifferent year in equities, and a difficult year for bonds, there could now be a real reason for institutional investors to look at hedge funds.

We've got an opportunity here for a fairly solid year across the strategies, with the only caveat being the long/short community, because of their net long bias. For hedge funds it should be an important year, as they become more institutionalised as an asset class.


Eric Bisonnier – EIM

We're looking at two basic scenarios which will largely affect the way hedge fund strategies work out this year.

The first involves a low volatility market, where interest rates will be range bound. Equity markets will probably not move that much, although commodities will look better because of expectations of Chinese growth. Under this scenario we'd be looking at a basic continuation of the economic background, a benign economy with decent earnings. Improving corporate balance sheets would be a major factor.

Under these circumstances, credit strategies will perform the best, plus some long/short equity, plus potentially fixed income arbitrage. Directional, macro, CTA, and convertibles will be more difficult.

The alternative scenario sees inflation building up in the US, a slower economy, and a re-rating of equity markets. This will create some volatility. Under that environment, and it's not certain that it will happen, directionals will work, and that could happen on a worldwide basis.

Non-volatility strategies would profit, and perhaps convertibles and fixed income arbitrage. Credit would be a tradeable put, but this would depend on how things change. I don't know if it will happen in six months or two years, but you'd need some long volatility strategies, and you'd need some directional strategies. We wouldn't want to have any long out-of-the-money puts.

It might be worth looking at long volatility strategies, because you'd not be losing money via time decay. Embedded flexibility would be important – if there's a problem on credit for example, then the portfolio will take some time to adjust.

Institutions are definitely starting to look at a broader range of strategy allocations, and have been doing so for the last 6-12 months. We're seeing a lot of new strategies appearing on the credit side, for example arbitraging CDOs and long/short credit strategies. We could see more in the way of volatility futures strategies, but this will depend on liquidity and other factors.

Returns are likely to be 8-10%, at the low end of the range. If things get more difficult, however, then there could be a lot of interesting opportunities, and returns at the higher end.


Stanley Fink – Man Group plc

Market volatility has picked up, which will probably result in convertible arbitrage becoming more interesting. I expect the strong trends on the dollar to continue, which will likely affect commodities and other markets. This should be good for trend-followers and CTAs. There should also be more M&A activity, which ought to boost merger arbitrage managers as well as long/short. There are many factors that worked to reduce hedge fund performance in 2004 that are not present now.

Hedge fund returns have not been falling as a result reduced capacity. Merger arbitrage has been at capacity however, and convertible arbitrage appeared to be having capacity problems last year as well. There was short-term volatility, and convertible arbitrage started to look expensive.

In terms of new strategies, a lot are mirrored by the size of the bank dealing rooms: the growth in the size of dealing rooms' capacity has not increased that significantly, when you look at everything together. Ten years ago, global macro was the dominant strategy, to the tune of 70% or more. Now 50% of them are equity based. In 10 years time the industry will look very different, for example we could see strategies based around reinsurance or weather derivatives.

I don't think there are too many hedge funds out there right now. There are an incredible number of people starting up, but many fail, and I'd rather be in an industry with a lot of start-ups and failures than one dominated by a few massive dinosaurs.

In terms of regulations, people should start to feel the impact of the US and German changes. The French may have to rewrite theirs, as they are getting out of step with the rest of Europe, but I don't expect any major new breakthroughs on the regulatory front. Hopefully we will end the year with better clarification of existing regulations.

One thing I would say is that the developed world has been focusing over the last 15 years on the accumulation of wealth. We have reached a point in the economic and demographic cycle where more people are retiring than are entering the workforce. We're going to see a different phase in the market with the growth of structured products to cope with this. The hedge funds industry is not currently focused on decumulation, as people age and retire, but it will have to be.


Ken Kinsey-Quick – Thames River Capital

I'm cautious on equity long/short as the market has had a huge run. Equity markets have rallied substantially over the last couple of years – the MSCI World is up 55% for example – but equities cannot outpace GDP growth at 4%. Nobody says equity markets are cheap at the moment, and they will likely struggle. All they need is one exogenous shock, which could put serious pressure on the US dollar, and most equity long/short funds will have a tough time. There will be some funds that will be able to take advantage of that situation, but they will be few and far between.

I'm still positive on distressed, although mainly ex-US as Basle II comes into force in the EU, and Japan still does not seem to have dealt with its non-performing loans.

Rising US interest rates will cause volatility to rise, and therefore should benefit volatility-based strategies. Credit strategies should be okay, unless some exogenous event causes spreads to blow out. Barring this, emerging markets should perform well as investors go in search of yield.

Merger arbitrage should also benefit. With markets more settled this year, and global growth expected to be 4% in 2005, we should see an increase in M&A activity. My wildcard top performer for 2005 would be convertible arbitrage, as everyone hates it at present, and it therefore makes for a perfect contrarian investment. As a strategy, it should also benefit from a rise in volatility.

I'm neutral on macro, as I feel it's dependent on trends, and you don't see many of them at present.

In terms of new strategies appearing on the scene, I think credit is just too wide a strategy allocation at the moment, and we will potentially see some new sub-strategies developing over the year, and becoming more formalised. Another growth area is likely to be commodity long/short, including energy funds. Real estate funds are also likely to stick their heads over the horizon – they won't become a formal strategy on their own, but people should be surprised by how many of them will be around by the end of the year.


Philip Richards – RAB Capital

We are in a global super-cycle being driven by China. Chinese demand for commodities is enormous, and is going to remain a major theme for this decade.

The rate of urbanisation in China stands at 50 million a year. The Chinese are engaged in a massive construction program, building cities, roads, airports and some 27 subway systems. Theyplan to build 50,000 miles of motorway over the next 5 years. That's more miles of motorway than the US have and its taken them 30 years to build that. The Chinese demand for metals is huge. The Chinese Ministry predict that an extra one billion pounds of copper will be needed each year, for several years. That's one additional world-beating mine (ie of the size of Grasberg) required each and every year. In contrast, demand for commodities in the US has fallen as GDP growth includes a higher percentage of services and software.

We are now able to invest in the former Soviet states in a way not possible before. This has created huge opportunities. We have made a lot of money in ex-Russian assets. Another new and exciting area for us is the South Atlantic; we hold large positions in Falkland Oil & Gas, and Falkland Gold. Oil resources in this area could prove to be the new North Sea. Many of the same factors are around today as were around in the 19th century when so many large fortunes were made. We are locating new deposits in new territories and discovering new technical and manufacturing processes, particularly in relation to extraction technology. As for returns, people speak of a lower return environment, but in our experience this unique 'cocktail of events' has meant that our returns have never been higher.

As for the dollar, the prospect of an even lower dollar is concentrating minds at the moment. Whilst the consensus view is that it may or may not go lower, I am of the firm view that it will go lower, the main driver being the trade imbalance. What was so shocking about the last set of US trade figures was the fact that they show the rate of growth of imports exceeding the growth of imports. International reserves will likely continue to be switched out of dollars into euros.

I see the gold price reaching 500 by the end of the year. As for the interest rate environment, I expect rates to rise a little as the year continues. Western equity markets overall will be weak positive or maybe negative.


Bill reeves – ClueCrest Capital Management

In general we believe that financial markets will continue to be driven predominantly by two broader forces, the first of these being the reversal of the savings dynamic between the US and its trading partners (particularly Asia), the second being ongoing balance sheet adjustments relating to global liability management. These forces are in many ways inextricably linked.

A rebalancing of the global savings and consumption dynamic will necessarily imply a combination of higher US real yields and lower US household spending relative to the rest of the world. It will also likely lead to further downward pressure on the US Dollar as US growth is redistributed away from the household sector toward the export sector. The ability of the Federal Reserve to restore US interest rates to more historically "normal" levels will increasingly depend less on the strength of the US economy and more on the strength of foreign demand. Robust foreign household demand would allow for a weaker Dollar that would in turn help cushion the impact of higher interest rates and facilitate a more gradual current account adjustment. Conversely, any failure to further stimulate foreign demand would inevitably increase the risks of global deflation during the next US economic downturn. It is our view that most foreign central bankers now appreciate this dynamic and that interest rates in Europe in particular will remain low and possibly even fall further over the course of 2005.

A second likely driver of financial markets over the next year is ongoing global balance sheet adjustments. These adjustments are in many ways being driven and reinforced by the current account dynamic mentioned above. Foreign central banks purchased just over one-half of all net US Treasury issuance in 2004 as the result of intervention. In fact, despite large US fiscal deficits, the net supply of Treasuries available to the private sector has been declining for about ten years. This reduction of supply, particularly over the last five years, has artificially lowered US yields and has served as a powerful reflationary force as it has driven a virtually unprecedented richening of both paper and more recently physical assets. Naturally, lower rates have increased pressure on those consumers, companies and countries with weaker balance sheets as the value of their long-term liabilities has increased while the opportunity to capture alpha to offset those liabilities has decreased. This phenomenon is heavily impacting pension and insurance investment decisions, reinforcing both the bullish dynamic in the long end of the fixed income market as well as the trend toward "alternative" investments. In extreme cases (GM for example) it may also lead to the forced reduction or restructuring of those long-term liabilities. Interestingly, a number of the Bush administration proposals to repair the Social Security system amount to just such a "restructuring." The behaviour of financial markets in 2005 will depend on the ability of global demand (particularly foreign household demand) to offset the inevitable drag stemming from the restructuring of US personal and national balance sheets. While an orderly adjustment is not impossible, this rebalancing process should prove to be a very delicate business indeed.


David Smith – GAM

Equity long/short is most probably going to see the best returns out of Europe, rather than Asia and the US. I don't think returns from long/short funds are going to be mind-blowing, probably in the area of 5-7%, which are still good, solid returns. But Europe could do very well indeed.

On the macro front some markets may suffer. In emerging markets particularly investors who have rushed in could get themselves into trouble if they're not careful. With macro and CTA strategies, there is the potential for some big numbers this year, particularly from the currency markets. The evolution of more international buying in the fixed income markets could also create opportunities in Europe, Asia, and possibly US debt. There are certainly some trades here you could put on, but a lot of this will depend on the macro funds to deliver it. Look to the third or fourth quarter for the potential for some real action from macro strategies.

Looking at credit, I don't think there's going to be massive blow-up in the market as a result of the long-credit bias. Managers now have the potential to short credit, and these instruments may also be of assistance to macro managers. Historically, macro funds have not done well in this kind of environment. Every fashionable investor, and there seem to be a lot of them around at the moment, has to have a credit long/short fund, as well as a LBO or CDO-type product. You could make a lot of money out of managers that are prepared to short credit. If you can find someone who can aggressively short credit, then you could do well.

I wouldn't be surprised if overall returns from hedge funds in 2004 would look much like 2004, I'm sorry to say.

In terms of asset flows, I understand the attractions of hedge funds and the challenges they offer investors, but I think long-only assets will also offer their rewards. People are getting a little more discerning, however, which is good. Thirty to fifty billion coming into hedge funds this year would be phenomenal, but I think we're unlikely to see it. I think fund managers will be disappointed by the institutional marketplace as buyers – I don't think they'll see the asset flows this year that they're expecting.