After a good first quarter (+3.13% on the Edhec Fund-of-Funds index), which saw the continuation of the stock market rally that had started in 2003, China and the United States decided to modify the basic elements of their monetary policy. Firstly, the Chinese announced their desire to drastically reduce their granting of bank loans. This involved violent trend reversals on the raw materials' markets (especially on base metals like copper) and the companies that depend on them. This also occurred in all Asian share markets with the notable exception of Japan. These initial blows entailed significant losses for directional managers and long/short stock managers involved in both regional funds and funds such as the American or Canadian small- and mid-caps, which are reliant on Asian growth.
In May of last year, the illogical progression of specific market configurations affected many strategies. This situation proves how the behaviour of the markets, and of each manager in these conditions, is essential for understanding alternative strategies.
The critical elements for understanding the performance of the strategies must include the management of the markets – their volatility, the rotations of all types that underpin them and their liquidity. Therefore, as if they were mocking the well-established relationships, the long/short manager indexes, having a typical net exposure to purchase in the market, lost as much money (-0.35% for the Edhec index) as the short-sellers (-0.24%), who were themselves in a short position.
Shares dropped dramatically in the last week of April and the first two weeks of May (MSCI Asia ex-Japan -10.3%, -14% in dollars, MSCI World -4.8%, -5.3% in dollars, Russell 2000 -7.8%) forcing the net long portfolios of long/short managers to greatly reduce their exposure to the market essentially for risk management and loss reduction issues. At the same time, the short-sellers, finally seeing their time come after 12 months of rising markets, increased their short positions to take advantage of this drastic fall.
The rise that followed was almost neutral on the long [long/short] managers, given their reduced exposure; however, it resulted in significant losses for the short-sellers, with over-exposed futures. It is thus indeed the behaviour of the markets and the adjustment of the managers to the markets which brought about an apparent correlation between them, and not merely the stock market rises.
May was exceptional in other respects. By taking the Edhec Hedge Fund indices, you realise that 9 strategies out of 12 were negative, and none of them had a higher performance than +0.40%. This reliance on a fall is exceptional. You need to go back to 1998 and, to a lesser extent, to 2002, to see this type of correlation. The second quarter ended with -1.16% for the FoF index.
The months that followed quickly plunged the markets into a worrying inertia, characterised by the panic that often hits managers and traders faced with growing uncertainties. We had to wait until the American elections, and their swift resolution, for investors to refocus on their respective areas, and forget the fear of a terrorist attack which people feared during the US electoral conventions and the Olympic Games.
This whole period was characterised by a drastic crushing of the implicit volatilities, which, in the American market, went from 20% to less than 13% on the VIX between the end of May and the end of September. The strategies relying on volatility suffered enormously, in particular volatility and European convertible arbitrages. Like each summer, liquidity dried up on the stock markets, reducing any possibility of performance of the long/short managers. In this difficult environment, the Edhec Fund of Funds index only yielded +0.40%
At the lowest point of the year – the end of August – the alternative was only a few base points above the monetary yield, seeming to prove that hedge funds were only a fad. For those involved in this industry for years, however, this was only a difficult period which they had successfully come through.
The last four months of the year were more in line with investors' expectations. Liquidity returned in September when the elections freed up inhibitions, and opportunities were made available to managers. Only volatility strategies continued to suffer.
In November, the significant movement of the dollar gave us a bonus end-of-year performance, while directional strategies finally got back to more attractive levels of performance. The Fund of Funds index generated +5.62% for these last 4 months, ending the year with an honourable 7.01%. Of course, this average performance hides major disparities, benefiting exposures to credit (+15.62% for the CSFB Distressed) or to emerging markets (+12.49%), which ended with a significant increase, to the detriment of directional strategies (CSFB +5.97%), such as Managed Futures, or of convertible arbitrage (CSFB +1.98%).
Finally, this year proves yet again the resilience of alternative multi-manager portfolios. Realistic performance targets, i.e. +7% to +10% currently, with a resistance to very big falls, make this investment highly useful in asset allocation. Therefore, with risk-free assets and bonds being at depressed levels of yield, and investment in the cheapest credit at these levels, a multi-manager portfolio can be of great use. But if you are looking for performances in the region of +15% or more, you will have to take many more risks.