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Market anomalies continue to recede

Originally published in the October 2009 issue

• Hedge fund managers have regained their self-confidence
• Liquidity and investability are key factors
• Hedge funds can look forward to a couple of good years

Hedge fund performance, as measured by the HFRX Global Hedge Index denominated in dollars, showed an upturn in the first three quarters of this year of more than 10%. The same index expressed in euros has risen by about the same number. This upturn is heartening, especially after last year’s difficulties. The stability and liquidity of the market have improved noticeably, and one result is that valuations have continued to rise. Despite the rebounds that have occurred this year, the price anomalies that arose in connection with last year’s financial crash have not been remedied in their entirety. Instead, various corrections remain in order to revert to a normal situation.

The emergency measures that hedge funds were forced to undertake after last autumn’s financial market drama continue to be phased out. Examples of such measures are gates and side pockets. Various studies show that impaired assets have steadily decreased during the year, and today they have fallen to around 10% of the total or below. This is positive for hedge funds. The liquidity of underlying investments has improved substantially. Hedge funds have thus been able to use mark-to-market valuations of their holdings instead of employing the “prudence principle” prescribed in accounting rules. This has helped hedge funds achieve good price performance this year. Today most such corrections have been carried out, but not all. Surveys also indicate that flows of hedge fund assets have again turned positive. The first signals of this change came in April and May, and since then the situation has slowly improved.

Since spring, equity long/short funds have shifted their focus from what can be characterised as quality investments and have targeted somewhat lower quality as a way of trying to generate higher returns. Part of the picture is that the net exposure of equity long/short funds has moved from well below historical averages to about average. It thus seems as if managers have regained their self-confidence.

The competitors of hedge funds are slowly returning to the market, to the extent that some banks have started hiring more people for their trading departments. Before the crisis, there was incredibly strong competition for good business transactions, hedge fund capital was twice as large as today and banks still had high trading activity. Today there is considerably less competition, which improves the opportunities for hedge funds to generate value. With everything else being equal, this should give hedge funds a couple of good years ahead.

Market trends
For some time, we have been pointing out factors that investors regard as important when putting their capital into hedge funds. Among these factors are liquidity in hedge funds, a good trading cycle for investors and transparency.

We are not alone in thinking that the above factors are important. The response to this by hedge funds and their organisations is to list themselves according to more investor-friendly regulations. Listings in tax havens and long lock-up periods have been widespread for many years, but today simpler fund regulations seem to be gaining ground. The trend towards being more liquid and transparent has only just begun, and we expect to see considerably more of this in the next few years.

During and after the financial crisis, various demands for regulation of the hedge fund market have been issued by prominent politicians in many countries and of many ideological persuasions. A likely trend towards a more regulated market is thus another factor to take into account. This will be a race against time: whether this will occur via self-regulation – with the hedge fund market reforming itself – or by means of legislation. There are many indications that the outcome will be acombination. The recent G20 meeting in Pittsburgh revealed a firm standpoint from the policy makers to further reform the financial business throughout the world thereby affecting hedge funds. This will most probably result in higher capital requirements for banks, and thus, making an impact on hedge funds ability to leverage their assets.

Furthermore, the meeting resulted in a wish to improve or change over-the-counter derivatives markets so that these transactions will preferably be carried out via exchanges instead. At the moment it feels like the legislative side has gained momentum and the answers from the hedge fund community will be interesting to take part of in the coming months. The race is on…

Our market view
As for hedge fund strategies, we have a positive view of equity long/short, fixed income and macro. We are still more reserved about distressed and event driven strategies.

Within equity long/short strategies, we are positive towards all sub-segments. Factors to take into account here are what proportion of beta or market return we get. Certain portions of emerging markets still have terms and conditions that make it difficult to hedge against downturns. Another factor to bear in mind is assessments of how different currencies will perform.

Within fixed income, we are positive towards credit long/short and directional plays, but cautious about relative value for the time being. As for distressed strategies, we are especially positive towards long/short, while we are holding off investing in long positions.

Event driven strategies do not stand out either positively or negatively, which means that we have a wait-and-see attitude. As for macro, finally, we are positive towards both CTA (commodity trading advisor) and global macro. CTA strategies have had a little tougher time this year compared to their successful 2008, but as markets stabilise further and trends become established, they will increasingly come into play. As for global macro strategies, the skill of the manager determines the return to an even greater degree. Properly handled, they offer fine opportunities to generate good returns in relation to risk.

To conclude, as the hedge fund environment normalises so should we as investors. Normality is more or less back and we can once again look at true value drivers going forward. We need to remember though how the regulatory changes will impact the hedge fund community and try to take advantage of this. All in all, we think this will benefit not only hedge funds but also us as investors.


Rickard Lundquist, Portfolio Specialist at SEB Private Banking, works within the private banking area, where he is responsible for hedge funds and commodities and where he works on the discretionary and advisory buy-side. He has a Masters degree in Business Administration and has consultancy experience in enhancing process steering in manufacturing.