2005: The Year Ahead

2004 came in like a lamb and went out like a lion

Philip Coggan
Originally published in the February 2005 issue

For hedge funds, 2004 came in like a lamb and went out like a lion. After a disappointing performance in the first few months of the year, hedge fund managers found some market movements to get their teeth into in the last quarter.

The CSFB Tremont Hedge fund index ended the year with a 9.6 per cent gain, thanks to returns of nearly 4.3 per cent in the last two months of the year. Only short sellers lost money in 2004. That was a far cry from April and May, when most hedge fund strategies were losing money.

That will provide ammunition for those in the industry who were getting increasingly illustrated by the growing chorus of hedge fund critics. Hedge funds may have the occasional bad month but they always bounce back. Clients of longonly fund managers, by contrast, are still nursing losses over a five year period.

But the critics are still talking. Keith Skeoch, chief executive of Standard Life Investments, dismissed hedge funds as a fad and said that investors should worry about their high death rate. "There is no evidence they (hedge funds) outperform in a growing market" he said.

Even Gavyn Davies, the ex-Goldman Sachs economist and BBC chairman who is one of the co-founders of Prisma Capital Partners, worried that the opportunities for hedge fund industry will be limited if equity returns in future years resemble those of 2003 and 2004.

To be fair to Mr Davies, that is not what he expects. He believes equity returns in the next two to three years will be "below what they have been in the last two or three years" since markets have rebounded from "extremely undervalued territory to…somewhere near normal valuations. In an environment such as that, hedge funds will continue to offer a very attractive enhancement to institutional portfolios." Many people would phrase the argument in these terms. In bullish tears for stock markets, hedge funds lag the returns of long-only managers. Their focus on absolute returns comes into its own when stock markets are declining, as they did in 2000, 2001 and 2002. So if you think the bear market ended in early 2003, it is time for hedge funds to get "back in their box".

Of course, that begs the obvious question of whether the bear market has really ended. Some commentators would say that, given the length and excesses of the bull market, the bear market was fairly modest; share prices never really fell to a cheap level. Measures such as dividend yield, book value or the cyclicallyadjusted price-earnings ratio still make Wall Street look expensive by historical standards. Bears argue that only excessively loose US fiscal and monetary policy have kept the economy afloat, particularly by allowing a housing bubble to replace a stock market one. If I knew where share prices were going to move this year, I would be setting up hedge funds, rather than writing about them. But even if the ability to go short of equities is not a great boon to hedge funds this year, it is a possibility that short-selling elsewhere might prove helpful.

Ten year government bond yields in the US are, at the time of writing, just 4.2 per cent. Yields may be distorted by Asian central bank buying. Nevertheless, with the Federal Reserve raising short rates, it is hard to imagine a situation this year where equities and government bonds both do well. If growth is strong, justifying forecasts for corporate profits and keeping the Fed vigilant, then bond yield must surely rise. But if growth disappoints, while the Fed keeps returning rate to "normal" levels, it will be hard for share prices to make progress.

There is also scope for short-selling in the credit markets. Spreads are narrow by historical standards, a situation that bulls justify by pointing to strong corporate cashflow, low default rates and a lack of supply. But it is hard to see how spreads can narrow from here. That leaves the market vulnerable to bad news, whether it comes from a slower US economy or perhaps rising issuance (bank lending to the corporate sector has already started to pick up). Many long-only managers will be locked into the bond markets, both government and corporate, because of their need for yield. That could give hedge funds the scope to outperform if yields rise and spreads widen.

But perhaps the bigger question for the hedge fund community is what happens to the dollar. The most difficult period of 2004 for hedge funds was when the dollar was rising and there are indications that the dollar's rally in the first few weeks of 2005 is causing some sectors of the industry (managed futures, macro funds) difficulty.

These seem to be two reasons for the correlation. The first is that the trend in the dollar has generally been down, and a lot of forecasters predict the US currency is in a long-term decline because of its massive current account deficit. Some hedge fund strategies tend to be natural trend-followers and thus they can be caught out when a trend suddenly reverses.

The second problem is that the dollar is the natural currency of financing for many hedge funds. A dollar decline does not, of course, hurt funds which own dollar-denominated assets and issue dollar-denominated shares. But if the fund is buying assets denominated in another currency, then dollar financing could be a problem. And that problem may be exacerbated by the recent increases in short term interest rates. When rates were at 1 per cent and the dollar was falling, the cost of financing could be zero or even negative. Those days may have disappeared for now.

When financing costs are rising, the natural temptation is to reduce some of the more speculative bets. But this could be a crowded trade particularly if the proprietary desks of the investment banks are trying to do the same thing. Price movements may be exacerbated.

The greatest problems may come in the areas where hedge fund activity is dominant. A report by Greenwich Associates recently found that hedge funds made up some 82 per cent of trading volume in US distressed debt; they also accounted for more than half the plain vanilla over-the-counter options contracts and for 70 per cent of the volume of exchange-traded funds. Of course, much of this trade will be two-way. But there is a danger if rates are rising, prices are falling and funds are suffering redemptions, that the desire to trade will be largely one-way.

All these are merely potential problems. There is nothing to say they will occur this year (although it seems likely that they will occur some time in the future). The second big question for hedge fund managers is whether such talk will dissuade investors from putting more money into the industry.

Here it is possible to be more optimistic. Yes, there is a chance that investors will get caught up in the enthusiasm for equities once again. For some, notably US and UK pension funds, a renewed bull market is the key to wiping out their deficits. But the painful losses suffered by funds during the 2000-03 bear market are a relatively recent memory. It seems unlikely that they will want to repeat their mistake of the 1990s by putting all their eggs in the equity basket.

What else can they buy? Government bonds, certainly. But despite the best efforts of governments round the world, there are not enough bonds to absorb the world's investment dollars. and for those pension funds that are in deficit, buying bonds now simply locks in that shortfall.

Investment banks are offering liability-linked products, which use swaps in an effort to match pension fund cashflows. But those swaps, in turn, depend on the government bond market. Again, this will not solve the problem of funds already in deficit. And, at longer-dated maturities, some of these swaps will be expensive.

So investors will be prepared to look at alternatives. Some may turn to the traditional asset, real estate, which has performed pretty well in recent years. Others may look to private equity. Some may be intrigued by the commodity boom.

But hedge funds will receive their fair share of interest. The process may seem painfully slow, as trustees need to feel comfortable with the sector, as do the actuaries that advise them. The biggest funds will take the lead. Obstacles will remain. Many trustees will be aware of the unfavourable risk-reward equation; put 10 per cent of the portfolio in hedge funds and overall success will only be marginally boosted if things go well, but if things go wrong all the blame will be heaped on the trustees' shoulders. Fees still look rather too high for most trustees' liking.

But some of the ground work has already been done. The idea of investing in hedge funds is much less outlandish than it was five years ago. The structure of the industry is better understood. Short of some terrible scandal in the sector, rising inflows are set to continue this year.

Philip Coggan is Investment Editor of the Financial Times