The year 2010 was a challenging one for investors. Clarity remained elusive and market moves did not reflect changes in fundamental economic data. Hedge funds, with a wider range of tools to exploit opportunities, were on average able to post attractive returns, on a risk-adjusted basis. What is important to note, however, is the dispersion within this figure. Deciding how much of a portfolio to allocate to hedge funds and then picking “best of breed” is no longer enough. How you allocate within hedge fund strategies is just as crucial. Therefore let’s look at where we’ve come from, where we’re going and how to best invest…

How has the economy fared?
From bank bailouts to country rescue packages, containing the contagion was difficult. In the US, markets were rocked by the possibility of banks being unable to foreclose. The UK elected a coalition government with all the ambiguity of a new structure of leadership. Investors swayed from “deflation” to “inflation” and even “stagflation” concerns and currency wars increased political tensions. Chinese inflation numbers were called into question, potentially hiding a more challenging environment and Korean missiles did nothing to bring calm. Systematic risks remained and throughout the year it was unclear what government policy moves would be.

Have hedge funds fared any better?
The hedge fund industry had issues of its own. Disappointed and disillusioned, many investors stayed away from the asset class. However, many funds generated some highly attractive returns, in a much steadier, lower volatile way than the equity indices, and net outflows finally reversed. Of crucial importance was picking the right strategy, seen in Fig.1, which shows the wide divergence of performances. Betting on the best performing strategy would have earned you over 160% more than if you invested in the worst, during this two year period.

Picking the right strategy
In a volatile and sentiment driven market, high beta funds benefitted as investors played a “risk-on/risk-off” strategy. In the same vein, hedge funds exposed to emerging markets directly or playing them indirectly through gold and precious metals, as well as for a store of value in times of uncertainty, performed well. In stark contrast, the defensively positioned suffered, none more so than dedicated short managers. Funds focused on fundamentals and relying on intrinsic value to be restored were disappointed and market neutral funds did not see the dispersion in returns they needed.

Can emerging markets save us?
Within developed markets, the conditions for a self-sustaining recovery are not there yet. Economies in the US, UK and EU remain heavily dependent on the consumer and with the amount of de-leveraging taking place, access to credit remains limited, therefore capping their ability to spend. Moreover, stubbornly high unemployment does nothing for their willingness to do so. This supports the case that investors may continue to look to emerging markets for more attractive growth rates and investment opportunities. However, be warned. Not all emerging economies are the same and a pithy abbreviation does not necessarily equate to a profitable investment. Therefore be wary of “acronym over-exuberance” and instead invest with managers aware that a consumption story in China can sometimes be played more smartly via a company elsewhere, where valuations have not been stretched and price arbitrage opportunities remain. This differentiation theme extends beyond countries to within sectors, companies, parts of their capital structure, etc.

Invest with flexible managers
In order to play this strategy invest with flexible managers able to react to the quickly changing environment and nimble enough to exploit opportunities when they present themselves. Interesting to note is the focus on investor flows into the larger funds, a trend that should change as confidence grows. With respect to liquidity, there remains a place in portfolios for managers invested in both liquid and non-liquid assets with emphasis on the terms being appropriate. A liquidity mismatch risks the imposing of gates, side-pockets etc. For this reason, the fund of funds industry has come under immense pressure. Investors are demanding they offer something to compensate for the extra layer of fees and less frequent access to capital. Some offer an attractive way to gain access to complex and higher risk strategies in a more diversified and lower risk way as well as providing uncorrelated returns, and it is these funds that can best benefit a portfolio.

Watch the correlation!
Correlation is a key issue. The commodity markets, for example, historically relied upon to diversify a portfolio, have instead been traded in line with other risk-assets. Therefore hedge funds provide a smarter way to play the asset class, actively managed and able to exploit cross-commodity arbitrage opportunities.

Conclusion
Despite a less than rosy economic outlook, hedge funds are well positioned to exploit the opportunities within the markets and as an investor, differentiating within these asset classes is crucial. Strategy choice matters.

Gemma Godfrey is the Head of Research and chairs the Investment Committee of Credo Capital. Prior to this, she was a Fund Manager of the Julius Baer Global Emerging Markets Stock Fund and responsible for Latin American Investments whilst at GAM.