YTD – Why the Sluggish Performance?

Hedge funds make money in rising markets. They make money in falling

Phillip Coggan
Originally published in the October 2004 issue

Hedge funds make money in rising markets. They make money in falling markets. But can they make money in flat markets? This year, the record has been mixed. According to EdHec, the French business school, as of end August, seven of the 13 hedge fund categories had delivered a cumulative return so far this year of less than 2 per cent. In the months of April and May, nine out of the 13 categories experienced losses.

Of course, at the aggregate level, such losses have been trivial relative to the kind of plunges suffered by equity investors in recent years. Nevertheless, they were probably not the kind of returns that investors were expecting, and they have occurred just as the mainstream institutional sector appeared to have embraced the charms of the hedge fund industry.

The difficult time hedge funds have experienced this year raises some serious questions. How does the industry generate its returns (an issue that has puzzled observers for some time)? How diversified are the various strategies? What is the link between hedge fund performance and market volatility? There are several potential answers to these questions. The first is that hedge funds depend on trends to make money. They act as momentum players, seeking to be nimble in buying early and getting out when the trend starts to turn. They use technical analysis to help them follow this strategy and the skills built up at the investment bank trading desks from which many of them sprung. The best tradershave a "nose" for the market, sensing where the balance of money is heading and using the bank's capital to make short-term bets on the trend.

In theory, with so many different asset classes to choose from, there should be a lot of different trend bets to make. As a result, it should be rare for all their bets to go wrong at the same time. So why did the theory not work this time? One answer could be that different types of hedge funds were making a similar bet at the start of the year. They were borrowing in dollars at low interest rates and using the proceeds to invest in a series of higher risk assets, from commodities through emerging market debt to Asian equities.

Those bets began to go wrong in the spring when it became apparent that the Federal Reserve would start to increase interest rates in the summer, rather than waiting until 2005, as many had previously hoped. Suddenly the cost of finance started to rise and the dollar, previously the seven stone weakling of the financial markets, stopped getting sand kicked in its face. Hedge funds rushed to unwind their positions. Virtually all assets lost money in April and May; about the only thing that was rising was the dollar. That was bad news of course for funds that had borrowed in dollars to buy assets denominated in other currencies.

The end of the "carry trade", as it was called (although the term is usually restricted to the narrow business of borrowing short-term and buying bonds), certainly played its part in hitting returns in April and May. But can it plausibly be blamed for poor returns throughout the year?

After all, the dollar has actually dropped in trade-weighted terms over the course of the year, a trend which should have been good for the carry trade. US interest rates have only risen from 1 to 1.75 per cent so far, hardly a crippling increase. Some of those assets that were supposedly part of the carry trade – emerging market debt, commodities, Treasury bonds – are actually up on the year. This should not have been too disastrous for the industry.

In any case, why should so many different types of funds have been making the same sort of bet? It is easy to see why macro funds might have done so. It was probably the consensus bet at the start of the year that the dollar would weaken, because of the huge current account deficit. Similarly, many thought the Fed would be reluctant to raise rates before this November's presidential election. Managed futures funds, or CTAs, might have been following the same strategy for the trend-following reasons already cited.

But that still leaves almost a dozen other hedge fund categories that should not be suffering from this problem. Why should distressed debt or equity long-short have been affected? Perhaps some of these other types of funds were affected by the lack of market volatility. Certainly, the implied volatility of the equity market is low, as measured by the Vix index on the Chicago Board Options Exchange. At the time of writing, the Vix was just 15.2, low by the standards of the late 1990s and early 2000s.

This could affect hedge funds in two different ways. First, funds could be option buyers, purchasing out-of-the-money calls and puts in the hope of exploiting sharp movements in price. Such options may be cheap by historical standards. But because volatility is actually low, the options are expiring unexercised. Hedge funds are losing their premium income.

The other possibility is that hedge funds are option writers, selling calls and puts to other participants in the market. Such a steady income would allow a hedge fund to deliver a low absolute return mandate. The problem for these hedge funds is that their upfront premium income has fallen. While such an income would still be positive, it might not be sufficient to cover the cost of finance.

Some strategies may also be intrinsically long volatility. For example, convertible bond funds tend to buy the bonds (and short the equity). That makes them long the call option that is implicit within the convertible structure.

However, the real reason for the poor performance of hedge funds may be rather simpler. After all, the work done by Harry Kat, the professor risk management at the Cass Business School, has shown that portfolios of hedge funds show quite a high correlation with the S&P 500 index. In a mediocre year for equity markets, it is not surprising that long/short equity funds, one of the biggest categories in the industry, should have struggled. A further problem has been the lack of new issuance, thanks in part to sluggish stock markets but also to strong corporate cashflow which has reduced the volume of new bonds. Arbitrage possibilities have been few and far between.

So one explanation for the sluggish performance of hedge funds this year has been a kind of "perfect storm" where everything has gone wrong at one time: rising interest rates, sluggish equity returns, low volatility, lack of new issuance and so on. Such an unfavourable combination is unlikely to recur.

Indeed, perhaps the industry deserves credit for delivering absolute return at all in such circumstances. John Godden, managing director of HFR Asset management, argued at the recent Hedge 2004 conference, that the recent period of drawdowns was only the ninth worst since 1990. Previous drawdowns have been followed by periods of extremely strong performance. And there were signs that returns did start to pick up in September. Perhaps the worst is already over.

Nevertheless, investors still have some reason for concern. After all, much has been made of the diversity of the hedge fund industry. But did the widespread declines of April/May indicate it is not as diverse as its champions claim? Some hedge funds may be pursuing a strategy that Professor Kat has dubbed "picking up nickels in front of a steamroller". In other words, their tactics pick up small profits 99 per cent of the time (betting on spreads to narrow, for example) but which go disastrously wrong on the 100th occasion.

Another issue is whether the ability to go short is really such an advantage as hedge funds claim. According to figures from CSFB Tremont, short-sellers lost money over the five years to August 2004, a period when the US indices were declining. If those that devote 100 per cent of the time to the practice cannot make money in a bear market, how successful are those who only short on a part-time basis likely to be? Then there is the question of capacity. Was it simply coincidence that poor returns occurred when money was flooding into the sector? These seems to be evidence that the arbitrage opportunities may have been exhausted in the convertible sector. And it is not just hedge funds that are chasing alpha in these areas. Investment banks, pressured by lower fees elsewhere, seem to have stepped up their commitment to proprietary trading in an attempt to maintain profits. Can hedge funds take on the prop desks and win? Many in the industry argue, however, that even with $1trn of funds under management, the sector is still a small part of the fund management world. There are plenty of arbitrage opportunities available and always will be while non-profit-maximising players (central banks, index trackers) participate in the market.

They may be right but after the events of 2004, there is a greater onus on them to prove it.

Philip Coggan is Investment Editor of the Financial Times