At the end of 2011, we saw the disappointing performance of the hedge fund universe being pounced on by the media who questioned the value and relevance of the hedge fund model. The criticism was that the adverse market conditions that the industry faced in 2011 shouldn’t have impacted performance in the same way they did in 2008 as conditions were markedly different.
As we all know, in 2008, the hedge fund industry had to face the dual problem of a liquidity and market crisis. In 2011, despite the ongoing market and geo-political turmoil, there was no liquidity crisis. In fact, with Central Banks pumping liquidity into the beleaguered US and European markets fund managers were able to position their portfolios to take advantage of the opportunities on offer.
The main reason for the weak performance was the “saloon door” phenomenon. The unrelenting market stop-and-go during the second half of 2011 proved exceptionally costly in terms of risk management. One of the primary reasons for this was investor nervousness and global uncertainties, which forced managers to take defensive positions rather than exploiting market opportunities.
However, despite the negative media coverage and industry performance in 2011, a recent Preqin survey of over 60 institutional investors found that the majority intended to allocate more assets to the sector in 2012. In contrast, High Net Worth Individuals are expected to continue moving out of the space. According to the Scorpio Partnership, in the six months to November 2011, HNWIs shrank their hedge fund allocation of their total investments in alternatives from 58% to 35%. The headline finding was that one in five HNWIs plans to decrease his hedge fund allocation further in the next six months.
The results of these surveys are very revealing as to the core issue that is currently pervading the industry – a disconnection between expectation and reality. At present what we are seeing is that institutional investors currently have a better understanding of the underlying value of hedge funds, which is their ability to produce attractive risk-adjusted returns.
As an industry we therefore need to do more to breakdown the idea of a hedge fund “asset class” and help investors, in particular the less sophisticated, to understand the benefits of the underlying strategies in a broader portfolio context. 2012 therefore needs to be a year where the industry not only focuses on performance but re-engages with its investors.
As we head into 2012, the global economic outlook is still highly uncertain. Fundamentally, the world still has too much debt and the situation is far from improving. We are also currently witnessing a mild recession in Europe, central banks flooding liquidity into the market in the US and in Europe and heightened levels of inflation in Asia. All this leads us to think that any outcome is possible for 2012. As a result we expect to see institutional investors continue to turn to the hedge fund industry for risk adjusted returns. Specifically, given the global economic uncertainty we believe that there are a number of strategies and approaches that will perform particularly well in 2012.
Firstly, we expect that there will be continued interest from institutional investors for uncorrelated strategies like CTAs and Market Neutral, as was the case towards the end of 2011.
CTA’s remain one of the strategies that we believe will continue to attract assets, as the combination of liquidity, diversification, low correlation and absolute performance remains very attractive for investors looking to diversify their portfolios. However, selecting the best CTA managers with scale and resources to invest in technology and research is critical as some fail to deliver on the combination of attributes that makes the strategy particularly valuable (see box-out for Dexia AM’s approach). There has also been much debate as to whether some CTA’s have become too big to trade effectively and this is certainly a criticism that in some circumstances is fair. Selection again is key, but in general we do see a continued growth in assets allocated to the strategy. We are also seeing investors looking at market neutral strategies in order to benefit from their low correlations with other asset classes and more directional alternative strategies. Such relative value strategies are really adding diversification to global portfolios and should take profit of an expected sideway environment for markets with a lot of dispersion.
Secondly, we believe that there will be an increased appetite for more opportunistic strategies such as High-Yield Corporate Credit which benefits from the liquidity-injection policies adopted by the Central Banks and the relatively good health of issuers. The one concern for this strategy is that ongoing European volatility will continue to be difficult to predict.
Finally, given the change in emphasis toward risk/liquidity-adjusted returns, Absolute Return UCITS products will continue to be a focus of investors who remain nervous and are looking for onshore regulated funds. The latter will continue to offer investors enhanced liquidity, enhanced security, and attractive returns in an environment where sustainable equity returns are regularly questioned and where bonds are no longer seen as safe haven assets and are producing very limited returns.
2012 is set to be another challenging year for investors; however we believe that the hedge fund industry will continue to profit from a more volatile world. As always some funds won’t perform as expected, however we believe that hedge fund strategies such as CTAs, Relative Value strategies, High Yield Corporate Credit etc. will become an increasingly integral part of investors’ asset allocation mix.
Dexia AM systematic funds, a different approach with a proven track record
During 2009 and 2011, which have been among the most difficult years in CTAs history, the fund proved its resilience delivering positive returns each year. Since 2007, the fund has achieved a 10 per cent annualised return. Below are the three characteristics that have helped deliver these returns:
• While most CTAs invest in all asset classes, fewer – like Dexia AM systematic funds – have a true diversified allocation; this allows each sector to contribute equally to fund performance.
• Most CTAs rely on systematic models that exclusively track trends through the quantitative analysis of market data or fundamentals. Such models detect trends and generate trade entry & exit signals that are then systematically executed by the CTAs. However, in addition, Dexia AM adds in two other sources of return based on (a) a contrarian approach and (b) pattern recognition techniques. These three strategies are low-correlated and, as a consequence, their interaction lowers portfolio volatility.
• Finally, the third key distinctive feature is dynamic riskmanagement. In order to keep the risk profile under control and to maintain portfolio diversification, the risk management models size each position on a daily basis. Accurate and effective risk modelization is a key element in controlling volatility and reducing drawdowns.
Fabrice Cuchet joined Dexia Asset Management (AM) in 1999. He has been the Global Head of Alternative Asset Management since 2006 and a member of the Executive Committee of DEXIA AM since 2009. Prior to these positions, he was involved in the launch and management of Dexia AM’s Long Short Equity process and Long Only quant and SRI equity funds.