The third quarter of 2008 has been flooded with, what can only be described as, extraordinary and extreme events occurring with both unpredictable speed and consequences. The sharp correction in commodities marked the beginning of the third quarter, with downward pressure on prices as illustrated by the significant speed at which the oil price dropped from its all time high of US$147 barrel. The inverse relationship of the US dollar with the commodity market provided a sharp strengthening of the currency, but financial focus quickly changed to the US government bailout of Fannie Mae and Freddie Mac. The bankruptcy of Lehman Brothers, marking the largest ever bank failure in history, the rescue of AIG and the acquisitions of many tier one global banks have all spelt out the end of an economic era.

With the recent events and in conjunction with the short-selling ban, hedge funds have been faced with a most challenging environment. Increased counterparty risk, in addition to the continued deleveraging and liquidation across most asset classes and regions, have seen dramatic global market swings not seen in over a decade. The Fannie Mae, Freddie Mac and AIG bailout in particular had significant consequences for the CDS market, with spreads widening to extreme levels. Strategy returns have varied considerably and within each strategy a great dispersion of performance among managers can be seen. With over 10,000 hedge funds in existence and the variation in performance, this year will inevitably see the industry consolidating. This consolidation, however, can actually be expected to improve the outlook for the industry in the long run.

Although challenging, the current turmoil will provide the best hedge fund managers with an environment ripe with opportunities in the mid to long term. The short term view is one of economic and financial difficulty with the focus on capital preservation. Going forward, however, the potential for alpha will increase due to the huge dislocations that will be seen in the markets as well as the foreseen reduction in bank proprietary trading desks. These desks will be reduced by number or at the very least by risk appetite. Therefore, it is likely that significant outperformance can be achieved from both manager selection and strategy allocation.

Managers that have performed strongly in the past will not necessarily be the managers selected going forward. In future, hedge fund allocators will focus much more on the operational set-up, liquidity terms and risk management. A stable and diversified client base is as important as a proper legal structure and a sound operational set-up with regard to systems, counterparty relationships and control mechanisms. Investors will ask for better liquidity terms and, therefore, increasingly focus on gates, side pockets and notice periods. The offered liquidity terms have to match with the liquidity of the underlying positions in the portfolio. Given the poor macroeconomic outlook and the expected sustained higher level of volatility, risk management processes will be analysed in more detail and strict stop loss policies as well as clear risk management guidelines and limits will be favoured. Investors will shy away from illiquid sectors, markets or asset classes and avoid strategies that are characterised by high hedge fund concentration.

Equity long/short strategies
The outlook for equity long/short managers is negative as they are likely to face a further few months of difficulties. However, once the markets normalise, managers will find a very rich opportunity set and the outlook will improve. Opportunities will occur as stock valuations have now significantly come down indiscriminately offering good opportunities for stock pickers. In addition, the number of players will decline and the reduced number of hedge funds and investment banks’ prop desks will lead to more inefficiencies.

In the current environment, low leverage and liquid portfolios will continue to be preferred. Large cap funds invested in developed markets are likely to navigate the current environment with more success, so are trading oriented and opportunistic managers. Small cap funds will continue to be impacted by the low level of liquidity in the space and emerging market funds could be impacted by significant outflows.

Statistical arbitrage and quantitative equity strategies
One should be cautiously optimistic about these strategies especially statistical arbitrage as they are able to provide liquidity to the markets in these volatile periods. Risk management is however of vital importance in finding the savviest operators in this space. Many funds appear not to have learnt their lesson from the severe quantitative fund liquidations of August 2007. The current elevated levels of cross-sectional volatility is, however, the real key as to why these strategies could deliver outsized returns even in the current environment. Traditional models focusing on valuation and other earnings based signals are to be avoided focusing predominantly on the shorter term momentum-driven funds and models that are more technical in construction overall.

Discretionary global macro strategies
Overall there is a positive outlook for directional macro managers applying strict risk management principles as the opportunity set increases significantly due to higher volatility and central bank activity or interventions. Macro funds have been among the best performing hedge fund styles during stress periods in the past due to their flexibility in adjusting exposures, the wide range of traded instruments, asset classes and structuring of trades. Furthermore, global macro funds increase the diversification of a fund of hedge funds in the current market turmoil as they consistently reduced their equity allocation earlier this year and shifted their exposure to currencies, interest rates and commodities.

Managers using rather technical and short-term factors are favoured compared to fundamental, value-driven and longer term oriented funds. Moreover, strict risk management guidelines, a focus on liquid investments and the willingness to cut losses early are very important attitudes in the current market environment to prevent bigger losses from erratic market moves.

CTA strategies
The outlook for both long and very short term CTA funds is positive. As these funds only operate in the most liquid futures markets they are currently relatively untouched by the current market turmoil: a crisis focusing on predominantly illiquidity and counterparty risks. Shorter term CTAs are also able to capitalise on the elevated levels of volatilities being seen in almost all asset classes at the moment. They will also dampen the increased volatilities that longer term trend followers currently exhibit by smoothing out the excess volatility within a clear longer term trend.

Volatility arbitrage
The outlook for volatility arbitrage is positive. Volatility arbitrage uses a statistically driven, non-directional approach to volatility trading. The strategy thrives on a volatility which is at an all time high as measured by the VIX Index. The strategy is also attractive from a risk management perspective. Managers primarily trade exchange listed products which avoid counter party risk. In volatile markets, managers stay in the most liquid markets such as options on indices and large cap stocks. Trades are usually short term and the worst case scenario is always hedged. Volatility arbitrage should continue to do well in the environment of head line risk, recession and overall uncertainty (see Fig.1).

Distressed strategies
While potentially challenging in the short-term, the outlook is quite positive in the intermediate to longer-term for distressed debt managers. The combination on a global scale of deleveraging of speculative lending across all credit markets (e.g. mortgages, bank loans, corporate bonds) implies a recession that is likely to be more severe than those of the 1990s or 2002. This deteriorating landscape is likely to lead to one of the greatest distressed opportunities in history. Already, technical selling pressure by banks and hedge funds combined with extremely poor economic prospects has pushed the CS High Yield Index to very wide levels. Nevertheless, distressed managers need to be selective in accumulating assets as economic fundamentals are likely to continue to decline leading to credit deterioration, and access to capital is likely to remain constrained (even in the face of Herculean government efforts to restore liquidity). This could lead to rising and higher level of defaults as well as lower recovery rates than in prior distressed cycles (see Fig.2).

It has been a very difficult third quarter for hedge funds, which will undoubtedly result in a fourth quarter that is challenging for managers to produce excess returns. Diversification across regions, strategies and asset classes will be of vital importance in order to spread the beta risk and limit further losses. Competitor advantage will lie in the ability to optimise the diversification of risk factors in order to maximise the stability of a portfolio and reduce the potential tail risk factors. Liquid and shorter term, more opportunistic strategies will be favoured over the fundamentally-driven, longer term focused approaches.

In both the medium and longer term, plentiful opportunities are apparent but currently the key focus is on preserving capital through this tricky and unprecedented time.