Fund of hedge fund managers are not entirely independent of market conditions according to Standard & Poors' latest update on the sector.

S&P's figures for the first six months of 2005 have revealed disappointing results despite the first quarter starting fairly well. The second half of March saw the beginning of a period of generally disappointing returns that continued into April and May with widening credit spreads and trend reversals proving a drag on the sector.

"Some funds-of-hedge-funds are managed for -- and generally achieve -- independence of market direction," said Randal Goldsmith, funds-of-hedge-funds sector specialist at S&P. "But general market factors such as historically low interest rates, tight credit spreads, lack of volatility and trendless markets have been affecting returns."

Falling equity markets in April also had a significant impact on funds-of-hedge-funds with large allocations to equity long/short funds, and in particular to those funds-of-hedge-funds that include long-only funds. Generally speaking, however, funds in the S&P funds-of-hedge-funds review saw good returns.

The managers of funds-of-hedge-funds interviewed for the update were cautious about the coming months. Collins Stewart, for instance, is wary of equity markets on a two-year view, and is likely to reflect this in its portfolios by adding to the CF Bespoke fund, a bear fund with a swap structure to protect against market falls. The team is most cautious on US equities and has been reducing exposure to managers in this region.

The team at Estrategias de Bajo Riesgo reports difficulty in finding new potential investments, as a growing percentage of funds do not meet their strict qualitative investment criteria. They have reduced exposure to convertible arbitrage funds, but are holding on to what remains in the short term in the belief that now is not the time to sell.

Kier Boley of GAM Emerging Markets is positive on the outlook for emerging markets over the long term, but believes that they will not make much progress while US rates continue to rise.

Despite the setback to performance, there have been few redemptions from the funds included in S&P's monitor. Some, such as the Collins Stewart "hybrid" balanced managed funds-of-hedge-funds, have actually seen strong inflows. This is consistent with the general industry trend: Tremont estimates that the industry saw net inflows of USD 24.6bn in the first quarter. Convertible arbitrage funds were the exception, however, and saw their third consecutive net quarterly outflow.

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