At the start of last summer the credit crunch was a problem in one small part of the US mortgage market. A year on and the repercussions from the sub-prime crisis are still reverberating throughout the world's financial markets. Despite notable failures – two of Bear Stearns structured credit hedge funds were an important catalyst in the credit market implosion – banks rather than hedge funds have borne the brunt of the fallout.

Risk, meanwhile, has been reassessed and re-priced, as investors have accepted that the benign years of easy credit are over and face up to a harsher macroeconomic environment of lower growth and higher inflation. This profound shake-up of the financial landscape has altered both the investment patterns of the hedge fund industry and its relationship with its investors and bankers.

At first glance, an aggregate snapshot of the industry is not encouraging. Performance year-to-date is flat, inflows have dried up and the environment for new fund launches is tougher than for many years. At the end of May, the HFRI Fund Weighted Composite Index compiled by Hedge Fund Research (HFR) had gained only 0.11%, while its Fund of Funds Composite Index was down by 1.45%. Industry inflows, after several years of strong growth, have temporarily ground to a halt. The first quarter's net inflow of US$16.5 billion, based on HFR data, was only 0.9% of assets under management and the smallest quarterly increase since the industry experienced a net redemption in the fourth quarter of 2005. New fund launches, meanwhile, slowed in the first quarter to their lowest level since 2000. HFR reports 247 new fund launches in the quarter while 170 went out of business, with single manager hedge funds experiencing the highest level of liquidations

Macro resurgence

An aggregate picture, of course, never tells the complete story. Recent performance at the strategy level illustrates the fundamental change in global macroeconomic conditions. Macro strategies have been the top performers, with gains of 5.4% year-to-date at the end of May according to HFR, while the sub-set following quantitative trend-following strategies returned 9.6% (see Table.1). There is a strong sense too among fund managers that global macro's resurgence could prove durable.

"For several years global macro has been a sleepy strategy," says Joseph Burns, Head of Investments Europe and Asia at Ivy Asset Management. "But the relatively strong returns of late represent a range of opportunities that we believe will be available for several years. It's not just a short-term rally while other strategies struggle."

The credit crunch marked the end of the 'Great Moderation', a period of more than two decades during which the volatility of both GDP growth and inflation markedly decreased. Over the last five years, cheap and readily available credit encouraged the use of high leverage, while the 'search for yield' spurred financial innovation in derivatives and underpinned the popularity of highly leveraged credit-based strategies. But, as Clarium Capital Management, a west coast US-based discretionary global macro fund with US$6.4 billion AUM andone of the year's best performers, explained in a statement in June, "While the world has enjoyed 25 years of strong growth and modest volatility, fiscal, demographic, geopolitical, geologic and financials strains have mounted."

Exploiting those strains is presenting global macro fund managers with investment opportunities. "The reason why global macro is performing well is that it is flexible and multi-strategy, investing in equities, bonds and currencies," says Randall Dillard, Partner and Chief Investment Officer of Liongate Capital Management, a London-based fund of hedge funds. "It has been successful because managers have rapidly deployed capital which can adjust to volatile markets."

Much of this volatility will have far reaching consequences. The credit bubble has burst, sparking a growth slowdown that has coincided with an upsurge in inflation driven by the boom in commodity prices. The bull markets in oil, agricultural and industrial commodities are strongly underpinned by the fundamentals of supply and demand, linked to the rapid development of large emerging market countries, notably China. The rise of new economic powers also alters the balance of global political power and, longer-term, could question the dollar's position as the world's reserve currency. Central bank policymakers, meanwhile, faced with the prospect of stagflation for the first time since the 1970s are not acting in unison. There are no quick solutions, either, to the global food crisis or to the possibility that global oil production may be close to its high water mark.

As the Clarium statement notes, "Although the ultimate resolution of these tensions remains difficult to predict, it seems unlikely that the placid growth trajectory of prior years will persist, implying an eventual deleveraging in almost all future economic configurations. At the same time, geologic constraints (especially those relating to energy) coupled with central bank reactions to fiscal and other crises would produce inflationary countertrends. If all this is true, outperforming portfolios would be those that are positioned for an increasingly divergent range of outcomes, roughly divided on inflationary/deflationary lines."

Fund of funds managers have arrived at similar conclusions about the prospects for global macro. "In the last half of 2007, we made decisions about what would drive returns this year in GAM Diversity, our multi-strategy fund of hedge funds," says Sophia Brickell, Investment Specialist in GAM's multi-manager team. "We pulled down our allocation to equity hedge, which is normally in a range of 40-60%, to just below 40% and increased our exposure to trading strategies (which comprises discretionary and systematic macro strategies along with trend and non-trend managers) from a neutral to an overweight 33-25%. We are pleased with how it is working, it was clearly the right decision."

At the individual fund level, the influence of the commodity boom is evident: the lists of best performers for 2008 contain a high proportion of commodity-based strategies. For example, funds such as Mulvaney Global Markets, The Clive Fund and Chilton GL Natural Resources International have gained 25-50% so far this year. Strong commodity price trends also partly explain the aggregate outperformance of quantitative relative to discretionary macro strategies this year, although these returns can be subject to downside volatility. "By its nature our long-term strategy can usually be expected to drawdown at major turning points," explains Paul Mulvaney.

Winners and Loser

John Paulson founded Paulson & Co 14 years ago and has US$33 billion in assets under management. In 2007 the Paulson Advantage Plus Fund returned 158.75%. Paulson established short positions in the mortgage market in 2006 correctly betting on emerging problems in the sub-prime market, achieving highreturns with little leverage. This year, as of early June, Paulson's credit funds are up 10-15% for the year and he remains negative about the prospects for housing markets. At a hedge fund conference in Monaco in June he said mortgage-related losses for troubled financial institutions could reach US$1,300 billion, compared with writedowns so far of US$380 billion.

In early March 2008, Peloton Partners, a US$3 billion hedge fund run by former Goldman Sachs traders Ron Beller and Geoff Grant was forced to liquidate its two investment funds, after they could no longer meet margin calls. Peloton's ABS fund was one of 2007's best performers with returns of 87% after betting against sub-prime debt. But Peloton ran into trouble by searching for value too soon in assets hit by the credit crisis. As contagion spread to highly rated assets, Peloton's US$6 billion long position in the ABX index suffered losses and it was pushed into forced asset sales by rising margin calls. Following a well-worn path among failed hedge fund managers, Grant is already planning the launch in September of a new fund, LiquidMacro.

Manager of the Mulvaney Global Markets Fund, a long-term systematic trend following programme covering the major financial and commodity futures markets. "But the significantly higher volatility created by a crisis often generates a range of opportunities and returns pick up strongly in subsequent months." Last July and August, for example, the fund fell by 33%, but has since gained 63% and, as of the end of June, was up 50% year-to-date.

Emerging markets rollercoaster

directional trends also helps explain why, on a regional breakdown, Asia ex-Japan has been the worst performing hedge fund index this year. In 2007, for example, 788 China Fund, an equity directional fund focused on Chinese stocks, was one of the top performing funds, with returns of 115%. As of the end of May, it had become one of this year's worst performers, with losses of 49%.

Earlier this year, explaining the fund's drawdowns in a fact sheet for investors, fund manager Jacques Mechelany said, "We strongly believe that the Chinese financial markets will 'de-couple' from western markets in the coming months and resume their bullish trend. We view current fears from foreign investors as being exaggerated and out of phase with the situation on the ground."

But while few would argue against China's growing importance in the world economy over the long-term, not all hedge fund managers are prepared to weather such volatility. "We are believers in decoupling over the long-term, varying by asset class and geography. It is difficult to believe that there will be much decoupling over a period of months or quarters," says Ivy's Burns. "We find it no surprise that those emerging market equity managers narrowly focused and long biased, needing leverage and a directional tail wind to generate returns, have struggled. We are seeking to diversify among more managers in this environment and to invest more widely across the pan-Asian region. We favour managers focused on generating returns from non-directional sources, such as relative value and volatility-based strategies."

This decreasing appetite for strategies dependent on market factors is a growing trend among investors in equities. "We are seeing much more appetite for alpha market neutral strategies and less for equity long/short that has a high degree of beta," says Bill Maldonado, Head of Alternative Investments at Halbis Capital Management. "The market turmoil is sorting the wheat from the chaff. Those strategies that offer true alpha are emerging from the alternative beta."

The corollary to the reinvigoration of global macro is the poor performance, this year, of credit-based hedge fund indices, such as corporate fixed income and convertible arbitrage. "These strategies have some combination of credit and leverage embedded in them which has been a necessity for return generation," says Burns. "Given the credit crunch and deleveraging globally, it is unsurprising that they face continuing pressures."

Opportunities within the strategy space, however, are still available for those who can find the right managers. "Whilst these convergence-based strategies typically offer less return dispersion, there is an increasingly attractive subset of managers who are outperforming their peers in fixed income convertible arbitrage," adds Burns.

Perhaps surprisingly, the distressed/restructuring index is also among the year's worst performers, but it presents a good example of how the consensus is often right, but is always early. Companies have used the years of cheap credit and loose covenants to their advantage, which will push the timing of distressed opportunities into the future. "The corporate default rate is about 2.2%, while in a normal market it is about 4%," says Liongate's Dillard. "So it's not surprising that high yield corporate bond pricing is fairly priced today, in contrast to distressed mortgage-backed bonds with default rates rising to unusual and alarming levels; but the corporate default rate is rising. With financial and corporate assets, the art is getting the investment timing right so you don't tie up capital too soon, suffering mark-to-market losses and lowering your returns. I would be cautious about buying distressed financial or corporate assets too early." Dillard believes that the distressed cycle is just starting and it is likely to last for the next three years.

This theme of investor appetite running ahead of investment opportunity is widespread. Investors expect distressed debt trading to be one of the top performers this year (see Fig.1). Fund managers, however, have a different opinion. "In our marketing trips across the world this year there have been two topics investors want to discuss: macro strategies and distressed debt," says GAM's Brickell. "But our underlying managers feel that it's just too early for distressed strategies; many assets are not even at stressed levels, let alone distressed. Bankruptcies have not taken off yet although, with the deteriorating economic environment, it's hard to believe they won't. We believe that distressed is a 20092010 story."

Prime candidates for change

Strategy performance trends, however, do not capture the full impact of the credit crunch on the hedge fund industry. Counterparty risk is one of the defining characteristics of the current crisis and has made its mark on the relationship between hedge funds and their prime brokers. The balance of power historically lay with the prime broker (following the LTCM crisis in 1998, it was the potential for a hedge fund disaster that was perceived as the threat to financial stability). Now, hedge funds are as concerned that a problem at a prime broker could drag their businesses down with it. "If a hedge fund has a prime broking relationship with a bank that runs into trouble, as Bear Stearns did, the fund needs to be able to move its business overnight to another prime broker," says Sarah Williamson, Founding Partner of HedgeMasters, a London-based consultancy.

Indeed, the rapid withdrawal of hedge fund assets, both cash balances and securities, was a significant contributor to the demise of Bear Stearns. Under the terms of most agreements, prime brokers assume re-hypothecation rights over their hedge fund clients' positions, which then become an important part of the bank's working capital.

Withdrawal of support, however, can work in both directions. The reduction of liquidity to hedge funds by prime brokers has been suggested as a contributory factor in recent high profile fund failures, such as the collapse of Peloton Partners (see Winners and Losers). In a letter to investors prior to its collapse Peloton said that credit providers had been "severely tightening terms without regard to the creditworthiness or track record of individual firms". But no hedge fund is guaranteed prime broking services. If a broker is concerned about its counterparty risk it has every right to withdraw. "Withdrawal of liquidity was probably part of the problem," says Duncan Crawford, Head of Capital Introductions in the Prime Brokerage Group of Newedge Group (UK). "But prime brokers have to look after their own risks and their own shareholders."

"Prime brokers are feeling the pinch on the financing side," says Maldonado. "Banks normally borrow short and lend long and make money from a positive yield curve, on average. But a prime broker is a 'reverse bank': it lends only overnight money to its clients and finances it at a slightly longer tenor, out to three and six months. The steep premium for three-month money compared with overnight has made the prime brokers' business inevitably less profitable."

The end result is that prime brokers are reassessing the types of hedge fund business they want. Previously, client relationships rather than the profitability or risk profile of prime broking services were the main consideration. But in a credit constrained environment there are tough decisions to make on where to allocate resources.

One new phenomenon is that a larger number of hedge funds are currently below their high water mark. This can trigger contractual clauses not performances fees, until the high water mark is regained. Prime brokers, and investors, must contend with hedge funds that have an incentive to regain that mark as quickly as possible, with potential implications for trading behaviour and the responsible use of leverage. Conversely, cash-rich hedge funds are being actively pursued for their prime-broking business. "One of our clients, a household hedge fund name, is being courted by a large European investment bank," says Williamson. "The bank sent 10 people to a meeting, hoping to show how serious they are, but unfortunately it smacked of desperation instead."

Hedge funds, meanwhile, are asking more questions about the creditworthiness of their broking counterparties. "The investment banks are telling us that we should only deal with one prime broker to build a closer relationship," says one fund manager who declined to be named. "At the moment we have one prime broker per fund, but we feel we need more than one. If we don't diversify and there's a run on the investment bank, then we have a serious problem." Hedge funds, therefore, have been looking for back-up prime brokers, or have been switching to one that is financially stronger. Using too many prime brokers, however, can present problems. In a report earlier this year, the US Government Accountability Office expressed concerns that the use of multiple prime brokers by hedge funds meant that no one broker may have all the data necessary to assess the total leverage used by a client.

Size and performance are important factors in this new balance of power. "I know of existing hedge funds whose terms with their prime brokers have changed," says Williamson. "Big, successful funds have improved their terms, while less successful ones are having to pay more." New start-ups are finding it more difficult to find prime broking relationships, while smaller funds can find that new minimum levels of income that their prime brokers wish to earn from the relationship are onerous relative to the size of their asset base.

The Three "Ps"

preference for big, well-established funds that are more institutionalised than their smaller, single manager brethren. This move towards a smaller number of managers controlling a larger proportion of hedge fund assets was evident before the credit crunch, but the problems of the last year have strengthened the trend. A greater focus by investors on risk management is part of the explanation. In recent years, according to Deutsche Bank's Annual Alternative Investment Survey, investors' top criteria for manager selection have been the "Three Ps". In order of importance, these are investment performance, investment philosophy and manager pedigree. In the latest survey, released in May, risk management has now displaced manager pedigree as the third most important factor.

But the credit crisis has not only underlined the importance of risk management, it has also highlighted its weaknesses. Critics have focused on an over-reliance in some institutions on models and single number risk metrics, such as VaR, which are unable to cope with catastrophic events at the tails of the probability spectrum. Fortunately, while an exceptionally painful experience, the market dislocations of the last year provide valuable information for future modelling and stress testing.

The need to use additional metrics, such as the absolute level of leverage, when assessing risk is now accepted. The majority of investors are still wary of using leverage in their investment strategies according to the Deutsche Bank survey (see Fig.2). Difficulties, this March, at Carlyle Capital, part of private equity firm Carlyle Group, for example, were greatly magnified by the 30 times leverage that the fund had applied to its portfolio of mortgage-backed securities. Leverage at hedge funds has also fallen by necessity: funds are constrained in their ability to lever up by access to liquidity and the higher cost of financing. There is a need, too, to adopt a qualitative approach to risk management in addition to a quantitative one. "You can create ratios and metrics until you are blue in the face, but they can change overnight if a fund changes strategy or enters new positions," says Williamson. "As an investor you need a fundamental understanding of what the hedge fund does."

Investors' desire for greater understanding of the risks they face has underpinned a move towards more liquid, transparent and less complex strategies. "Investors' initial reaction to last summer's market turmoil, was to redeem investments that offered monthly liquidity and put in redemption notices for less liquid strategies," says Newedge's Crawford. "Then, later, as the cash flowed in from the less liquid redemptions, it was reallocated back into more liquid strategies." Accompanying this trend has been a rise in the popularity of managed accounts. Offering daily liquidity and a notional funding requirement, managed accounts provide investors with greater transparency in their portfolios. "With, say, 10% of a portfolio in managed accounts, the next 20% in strategies offering weekly liquidity and so on up to those investments with long lock-ups and little transparency, an investor has a better idea, day-to-day, of what his positions are and an enhanced ability to close them out," notes Crawford.

Growing scrutiny

Investors are not the only ones trying to get a closer grip on the activities of hedge funds. In June, the Financial Services Authority (FSA) circumvented its usual lengthy consultation process to rush through a new regulation requiring the disclosure of short positions of 0.25% or more of the total shares outstanding in stocks undergoing rights issues. Shortly afterwards, in early July, the regulator said that holdings of contracts for difference should be disclosed as if they were shares. Given that the FSA estimates that CFDs account for almost a third of equity trading, it is understandable that the regulator should want to broaden oversight to include these derivatives, although some fund managers will inevitably view the change as an attack on the activities of activist and event-driven hedge funds.

The requirement to disclose short positions in companies making cash calls, however, is a departure fromthe FSA's principles-based approach to regulation, aimed narrowly at the short-selling activities of hedge funds in UK banking stocks. It has as much to do with fears for systemic financial stability should the banks fail to raise capital as a desire to regulate short-selling more closely. Nonetheless it has prompted strong reactions from hedge funds.

"Regulators always flail around to blame someone," says the manager of a global financials long/short fund. "The more stress the system is under, the more likely you are to see measures of this kind to protect it. But it is an ill-advised move that suggests the FSA is panicking. It also fails to grasp that every time a hedge fund goes short, a long position is created on the other side." Others, however, have more sympathy with the regulator. "It's very difficult to argue that hedge fund short-selling makes for a less efficient market," says one fund manager who wished to remain anonymous. "The FSA understands this, but there is clearly some leakage of sensitive information and at times, in some stocks, there are abnormal price movements."

If opinions are divided, what is clear is that additional compliance requirements are increasing the administrative burden facing hedge funds. Once again, it is larger funds with sophisticated administrative structures that can better cope with greater compliance requirements, further strengthening the trend towards institutionalisation.

Paradoxically, at the same time as short-selling in UK banking stocks is under scrutiny, hedge funds have been buyers and sub-underwriters in the recent round of bank rights issues and capital raisings. Up to a point, hedge funds are assuming a new role as providers of longer-term liquidity. The growth of the 'originate and distribute' banking model based on syndication has allowed hedge funds to step in and take more risk in areas traditionally the preserve of banks. Arguably, as the banks have become more constrained by the deterioration in their own balance sheets there is greater scope for hedge funds in this role in the post-crisis environment.

Certainly, hedge funds have the advantage that they are able to move very quickly. Some funds, for example, were only given 12 hours notice to decide whether they wanted to participate in Barclays' £4.5 billion capital raising. But it would be wrong to take the argument too far. Part of the hedge fund interest to buy Barclays is undoubtedly short covering, although this is difficult to prove, as the capital raising is not covered by the FSA's new rules on rights issues. The liquidity profile of hedge funds (the extent to which they can face short-term redemptions) and the fact that many are borrowing money from the banks to fund their trades, will limit the time period over which they are prepared to commit capital.

Upbeat investors

Hedge funds' involvement on both sides of the market for banking stocks underlines the industry's diversity and ability to make money across the cycle. These characteristics are not lost on investors, who appear upbeat about longer-term prospects, despite the current hiatus in aggregate performance. Even though industry inflows were very low in the first quarter at US$16.5 billion, respondents to Deutsche Bank's survey expect a median industry inflow of US$200 billion in 2008 (see Fig.3) Greenwich Associates, meanwhile, in a survey released in June, found that almost a quarter of US institutional investors planned to increase allocations to hedge funds by 2010, while only 2% planned to reduce them. For their part, hedge funds and fund of funds managers stand ready to meet the challenge. As Ivy Asset Management's Burns says, "It may not feel like it every day, but the opportunity set for hedge funds is as attractive as it has been in many years."