A Look Forward

Good managers shouldprofit from market uncertainty

Originally published in the May 2008 issue

The first quarter proved challenging for many hedge fund strategies and for many individual managers; in addition, the dispersion of returns between managers remained quite high. While returns varied across the different sub-strategies, a broad universe of funds finished the quarter down 2.78%, as measured by the HFRX index. Our current forward-looking outlook for the returns of a diversified pool of hedge funds is 8-10%. This is modestly lower than the levels we were looking for at the start of the year. The challenges facing the markets today are greater than they have been for some time, the environment will continue to change and will be faced with surprises, so one should not expect returns to be delivered in nice, neat 75 basis points monthly increments. We would expect a diversified portfolio of hedge funds to deliver this return stream with mid to high single digit volatility and attractive correlation characteristics versus the broader market stock and bond indexes. There are many obstacles facing the markets which we believe will prove a challenge for both traditional and hedge fund managers, however with this uncertainty and volatility comes opportunity and good hedge fund managers should be able to take advantage of the environment we see on the horizon.

The Hedge Fund Management Group, the external hedge fund business of Citi Alternative Investments, breaks the universe of hedge fund strategies down into four categories: Directional Equity, Directional Macro, Event Driven and Relative Value Arbitrage, with each of these categories divided into a number of specific sub-strategies. The expectations for returns associated with this diverse universe of strategies varies significantly, and the dispersion of returns associated with the actual performance of individual managers comprising each sub-strategy remains very high. We believe strongly that manager selection will be more important in 2008 than it was in 2007, and 2007 was a year in which it was about having capital deployed with the right managers. Having the right managers may add greater value than the actual strategy allocations. In addition, investors should continue to remain diversified by sampling from the many different ways to take risk across the spectrum of hedge fund strategies.

The average long/short manager did not have a great quarter, but relative to the performance of the equity markets most managers out performed the indices and protected capital in what was a difficult environment. It is important to realise that most long/short managers have a net long bias and do have a beta component to their returns. As one would expect, the better performing long/short managers were those that maintained a net short exposure or utilised out of the money put protection. Exposure to financials and commodities created significant volatility for managers, especially in late January and again in late March. During March some of the highest profile and best known managers in the hedge fund space experienced outsized drawdowns. Much of this appears to be a result of the sharp reversals in financials and credit that occurred in the second half of the month. While historically strong top tier managers may have suffered a difficult month, these managers did not wake up and go from strong alpha generators to below average firms. As a result of these recent events, certain managers and strategies should present attractive opportunities.


Overall, the outlook for Directional Equity remains constructive, with a particular focus on managers that utilise fundamental stock selection and proprietary research for identifying long and short ideas. Equity managers with a clear edge in alpha generation and generally more flexibility in adjusting their net exposure should be favoured over those with longer net exposure and higher betas. While we would maintain allocations to this sector, investors should expect to see higher volatility as we anticipate increased equity market volatility in the face of uncertainty on the strength of the US economy, direction of interest rates and the outlook for inflation. In addition, the market will need to focus on possible changes in government policies as the presidential election process heats up. We also believe there are interesting opportunities in both the international developed as well as in the emerging markets.

Directional Macro

The outlook for Directional Macro is neutral with a positive leaning tilt. Managers in this sector have seen an improvement in the opportunity set over the last several quarters. More importantly the equity tilt that many macro managers had in 2007 has been reduced and therefore the diversification benefit of holding macro funds has increased. Managers that utilise higher frequency trading strategies and both fundamental and technical factors in their decision process should be favoured.

In addition, these managers should be able to benefit from increased activity in the interest rate, currency and commodity markets. One should remember managers in this space tend to be just as comfortable trading from a long bias as they are from a short one; additionally, many will trade spread positions. Macro managers, especially those in the systematic space, continue to deliver returns that offer beneficial correlation characteristics for portfolios of both traditional stock and bond holdings, as well as portfolios of other hedge fund strategies. In general as the trades these managers are exposed to have extended, several have reduced the amount of risk they are taking. It is important to note that this could change quickly in this specific sector.


Event-Driven strategies are positioned with a neutral bias. Given the current and anticipated stress in the credit markets the environment looks less favourable for event-driven equity managers. Many financial buyers have been sidelined and the ability for companies to leverage their balance sheets has diminished. That said, we anticipate an increase in strategic acquisitions and mergers.

As a result, focus on event-driven equity managers that have operating experience and can initiate and drive strategic deals, as well as merger focused managers that can take advantage of strategic opportunities. Within the merger space, managers with a global focus or an ability to execute cross border deals should be favoured. Event-driven credit managers should offer interesting opportunities especially in the second half of the year. In fact, as the year unfolds, we anticipate the current stress in credit markets and dislocation in the structured finance markets to provide attractive return prospects.

Keep in mind the best returns from this space may not be achieved until 2009 or 2010. Within the credit sector, managers that focus on the loan markets look very interesting. Based on current loan prices and the senior secured nature and maturity profile of these securities, it is not unreasonable to expect managers that have the ability to perform solid credit work to be able to achieve returns in the mid-teens on a non-leveraged basis. On a risk-adjusted basis, this part of the credit sector would appear to offer better value than most equity-focused strategies. As the opportunity in the credit space unfolds, we would begin with managers that are focused higherup in the capital structure and only venture down the capital structure later in the year or in early 2009. Patience should be rewarded in this sector.

Relative Value

For the Relative Value category, we maintain a negative bias, as many of the trading strategies in this group require managers to leverage spreads. As a result, one is exposed to increased liquidity risk and a fair amount of the short tail risk, which is associated with the convergence trades often utilised within the strategy group.

In this sector we would utilise market neutral equity managers, especially those that focus on fundamental factors. We believe the current environment for the equity markets will create significant dispersion between pairs of stocks and the ability to capture this dispersion without taking on directional market exposure will be beneficial to managers that concentrate on these strategies. In particular we favour managers focused on specific sectors such as technology and health care.

As the year progresses, we anticipate opportunities to emerge in the convertible arbitrage sector. This sector has been largely uninteresting, but with recent events impacting the capital markets, this space is once again showing some signs of coming back to life. In addition, we believe some exposure to managers in the prime mortgage sector look interesting; however manager selection here will be critical as will focusing on the details of how the managers build and manage their portfolios.

If one is cautious, there are opportunities to take advantage from the dislocations that have occurred in the mortgage market.

Based on the outlook for expected returns and volatility coupled with the attractive correlation benefits of the asset class, a diversified portfolio of hedge fund strategies remains an attractive way to diversify and potentially add value to a balanced portfolio.

Investors should continue to remain diversified by sampling from the many different ways to take risk across the spectrum of hedge fund strategies.



Ray Nolte is the CEO of the Hedge Fund Management Group at Citi Alternative Investments. He also serves as the Chairman of the Hedge Fund Management Group’s Investment Committee. Before joining CAI in September 2005, he worked at Deutsche Bank from 1983 to 2005. Prior to that, he worked for Bankers Trust until the firm was acquired by Deutsche Bank in 1983. Nolte was the founder and Head of the Investment Committee for Deutsche Bank’s first fund of hedge funds. He built the DB ARS Fund of Fund platform to $7bn assets under management.

Citi Alternative Investments

Citi Alternative Investments is an alternative investment platform that manages a wide range of products across four asset classes, including private equity, hedge funds, real estate and structured products. CAI manages capital on behalf of Citi, as well as third-party institutional and high net worth investors. As of March 31, 2008, CAI had approxi-mately $59.3 billion of un-levered assets under management, ranking CAI among the world’s largest alternative asset managers. CAI’s goal is to enable its 14 investment centres to retain the entrepreneurial qualities required to capitalise on evolving opportuni-ties, while benefiting from the intellectual, operational and financial resources of Citi.