Hedge Funds Again Resemble Hedge Funds

SEB looks at the stabilization of hedge fund trading strategies

Originally published in the July 2009 issue

• Correlation with other asset classes has decreased
• Outflows have stabilised
• The risk of negative surprises is diminishing

After a turbulent 2008, hedge funds have been performing more favourably again. Collectively, they are up more than 2% since the beginning of 2009, calculated in US$ and with a low correlation to equities. This is positive news for hedge funds as an asset class and is another sign that their surroundings are beginning to normalise after last autumn’s systemic risk − good news for financial investors.

Although 2009 so far has been favourable to hedge funds, the picture has varied at the sub-category level. Convertible arbitrage, which took a heavy beating in the autumn of 2008, is up 14% this year according to the HFRX hedge fund index. Meanwhile one of last year’s stars, managed futures, is down 6% according to CSFB/Tremont. Portions of macro and equity long/short have performed well in 2009.

Good, but still risky
Yet it is still important to remember and take into account the enormous crash that hedge funds were part of during 2008. The reason is that the system is not yet healed, but the healing process has proceeded far enough that there are reasons to look at more fundamental factors.

One problem for hedge funds is continued worries about trading in various OTC derivatives, which for many have been an important element of their portfolios. In this market, liquidity has not yet recovered, and volume in commodities, for example, has halved since the first half of 2008. There are still outflows, but not at all on the same scale as only one quarter ago. In our assessment, the flow situation will improve further, provided that no negative external event occurs. We also believe that there will be a continued weeding out process among hedge funds that will favour large, institutional and successful funds.

What is important to us?

We are continuing to seek hedge funds with institutional behaviour and institutional organisation, clear risk mandates, low gearing and good liquidity that have coped well with the crisis. These are requirements that we share with the rest of the investor community in order to commit our funds to hedge funds today. It will lead to a better, more easily understood hedge fund world than the one we had before the crisis.

Various parliaments are currently discussing regulations that will undoubtedly affect hedge funds in the future. The asset class will probably become more regulated as a whole, but this will meanwhile reduce the risks to investors.

Hedge funds that are already strong will have an opportunity to further strengthen their position, and the investment opportunities appear attractive. This is because there is less competition for good ideas than a year ago, when the hedge fund asset class as a whole was nearly twice as large, and trading by major banks for their own account has decreased significantly.

Looking at strategies

At the strategy level, we have a positive view of equity long/short and fixed income. We are neutral towards distressed, event driven and macro/MTA strategies.

• In equity long/short we are positive towards all sub-categories, including equity trading and market neutral. In general, these funds are easy to understand and usually have functioning risk management systems. They also often have low gearing. In a world that is slowly returning to some sort of normal status, it is a good opportunity for investing in equities, and especially equities with built-in protection: equity long/short.

• As for fixed income we prefer credit long/short and directional fixed income. We are staying away from fixed income relative value. We have argued in favour of investments in corporate bonds, both investment grade and high yield, in the fixed income asset class, and the same positive analysis applies to credit long/short; the disadvantage is often poor liquidity.

• In distressed strategies, where we have a neutral view, we prefer distressed long/short to distressed long biased. The opportunities in distressed are beginning to be good, and even now it is possible to start building up holdings. It should be pointed out, however, that funds in the distressed category often have a positive correlation with the economic situation, and a drawn-out recession scenario in the world economy would result in weak performance.

• As for event driven and merger arbitrage, we have a neutral view of all sub-categories. We are not prioritising these strategies at the present time.

• In macro/CTA the picture is a little different. Strategies that use quantitative models are not working entirely optimally in the current market situation. We instead choose to focus our interest on macro, where hedge fund managers have manoeuvring room to display their talent. The disadvantage is that these strategies become dependent on managers and the teams behind them.


Rickard Lundquist is a Portfolio Specialist at SEB Private Banking, has 14 years of experience within the banking sector. He is responsible for Hedge Funds and commodities and works on the discretionary and advisory buy-side. He has a Masters degree in Business Administration.