The following article on trends in the global hedge funds industry is by Graham Wainer and Julian Howard of GAM Holdings, the Swiss-listed investment house.

The following article on trends in the global hedge funds
industry is by Graham Wainer and Julian Howard of GAM Holdings, the
Swiss-listed investment house. Wainer is global head of investments - managed portfolios
with overall responsibility for GAM's global private client and portfolio
management. Howard is investments communications director. Their views are
their own and not necessarily endorsed by this publication.

Hedge funds have had a tough decade. Over the last ten years
to the end of October 2013, the HFRX measure of hedge fund returns delivered
just 12 per cent versus 105 per cent for the S&P 500 equity index and 62
per cent for world government bonds. For investors expecting big things for the
fees they pay, this is hard to stomach. It’s not all bad news though because
with careful sifting, highly effective strategies can be identified and go on
to serve investors well. The starting point, however, has to be a recognition
that the hedge fund universe as a whole probably cannot meet the high
expectations demanded of it.

These expectations take the form of three broadly recognised
deliverables, namely strong absolute returns, a smooth “ride” and low
correlations to wider markets. Taking the first, many hedge funds now openly
admit they cannot gain an edge in an environment of low interest rates and
government intervention. Instead, the industry and its new institutional client
base are increasingly concentrating on the second two aims of low volatility and
low correlations to wider asset classes, i.e. a more modest “cash plus-plus”
offering. This is sensible repositioning and such characteristics would still
be valuable, albeit less attractive, commodities in portfolios today. But the
question remains whether even these less ambitious aspirations can be achieved
consistently.

Smooth risk-adjusted returns have always been perceived as a
traditional hedge fund strength. Key to producing these has been the ability to
keep any drawdowns as brief as possible by staging swift recoveries from any
setbacks. For example, the HFRX Macro/CTA index went on to perform after each
of its ten worst months for performance during the last decade. While one of
these tough months - August 2007 - did see a strong subsequent recovery by the hedgies,
the rest did not. Unlike bonds, which generally do have an inviolable pull to par when the
borrower repays the debt at the end of the term (default situations excepted),
hedge funds are only as good as the skill of their traders in limiting
volatility and reversing losses in a fast-changing investment environment.

Diversification and low correlations to wider markets form
the third plank of the hedge fund pitch, literally the “hedge” part of the name.
This also goes to the heart of the way many funds organise themselves, shaping
the strict risk budget policy many top houses impose on their traders. These
risk budgets are the investment management equivalent of the New York City taxi medallion, representing a
licence to do business within the Darwinian world of hedge fund trading. This
has to be earned from small beginnings but, as trust and ability are
demonstrated, the best traders are rewarded with more client money to invest.

Results

The results of this risk management discipline are clear to
see; from the end of 1989 (when meaningful data began) to the end of 2007, just
before the financial crisis, the HFRX Global Hedge Fund Index produced a flat
to positive return in 38 out of the 79 months in which the S&P 500 equity
index fell. This equates to an enviable “defence rate” of nearly 50 per cent
and a very tangible characteristic the industry can point to. But 2008 onwards
is a different story. The sample size is obviously smaller, but the
proportionally adjusted results are dramatically worse. Of 28 monthly drawdowns
posted by the S&P 500 index from the start of 2008 to end October 2013, the
HFRX was able to post a flat or positive return during just five of them. This
is a defence rate of just 18 per cent, compared with 46 per cent for world
government bonds.

All this would amount to quite an indictment of hedge funds
but investors should consider whether they ask too much of the sector. For
example, being able to demonstrate low correlation and diversification when
traditional asset classes sell off can sometimes be at odds with the demand for
swift performance recovery. It is not hard to imagine a situation in which
equities suddenly fall after a rally and those hedge funds that had participated
immediately cut their positions in order to preserve low correlation on the downside.
If they do this, then they have defended well and satisfied the low correlation
and diversification requirement.

But to then go on and stage the kind of quick recovery that
is so vital to creating a strong, smooth performance profile often requires re-engaging
in the very same asset class they have just sold out of. But not all is lost. Of
the 6,000 operators that make up the hedge fund universe there will always be
some who really can consistently deliver for their clients. Finding the next George
Soros is a tough call but wealth managers with dedicated research resources can
still help clients identify funds capable of delivering.

And market conditions could be turning more favourable too. Recently
there have been signs that dispersion, the rocket fuel of hedge fund
performance, might be coming back into markets. One vivid example in recent
months has been the divergence in monetary policy between the US and Europe.
The Federal Reserve will eventually taper its asset purchases but the UK has reiterated
its commitment to ultra-loose monetary policy while the ECB cut its repo rate
in early November. The ensuing opportunity bears a passing resemblance to the recent
yen carry trade in which hedge funds effectively borrowed in low interest rate Japan
and invested in virtually any higher-interest rate asset class to generate
healthy risk-adjusted profits on the difference. 

As the different components of the world economy recover at
their own pace this is just the kind of opportunity that may yet put hedge funds
back on their feet.