Comment: Hedge funds offer safe haven for 2006

Last year was a mixed year for hedge funds, but on balance it was much better than 2004, according to Thomas Della Casa, Investment Strategist with RMF.

At the beginning of the year arbitrageurs suffered from falling volatility in equity markets and commodity trading advisors (managed futures) lacked clear trends, but equity-weighted strategies benefited from positive equity markets right from the start. 
 
Brighter third quarter

Performance improved for nearly every hedge fund strategy in the third quarter. Equity markets in Europe, Asia and Latin America broke away from the sputtering US exchanges and prices there soared, particularly in Japan and Eastern Europe. The upward trend in energy prices was bolstered by Hurricanes Katrina and Rita in the southern US. In this environment, equity strategies with a focus on energy, emerging markets and special situations had the most success. Global macro managers were also able to position themselves well.

Managed futures funds finally saw clear trends and arbitrageurs benefited from increasing volatility. 

Nearly every strategy fared better in the year ended November than they did in the comparable period in 2004 (see table). With an average return of more than 10 per cent, distressed securities and long/short equity managers were the best performers, followed by event driven (just under 10 per cent). Diversified funds of hedge funds performed well in each month, once again proving their worth as portfolio diversifiers, though their performance fell between traditional base market global equities and global bonds. 
 

Relatively stable major trends

The trends initiated in Q3 2005 will likely have a positive effect on hedge funds in 2006. The continuing economic boom in Asia will help maintain momentum, with the Asian economy expected to outpace European growth in 2006 by two or threefold. The likelihood of a dramatic economic crisis similar to the ones that occurred at the end of the 80s or in 1997 has decreased as most Asian countries now have more stable fundamental data, higher credit standing and more competitive currencies, and are more integrated into the world economy. In addition, large countries like China and India are less dependent on exports than they were before, with a bourgeoning middle class generating greater domestic consumption.

As a rule, hedge funds can assess investment opportunities in developing markets in Asia better than traditional long-only funds. Alternative strategies are more effective in an environment with some inefficiencies and high volatility; second, strong economic growth is not a foregone conclusion in consistently bullish equity markets. Various tensions must also be taken into account, which experienced non-traditional managers can exploit better than traditional managers.

The boom in Asia is helping Japan to awaken from a 15-year slumber. Japan is best positioned to take on the role of Asia's economic engine. It has opened its economy, loosened the stranglehold once held by cartels, strengthened its domestic markets thanks to rising consumer demand and is producing top-quality products that are in demand not only in Asia but around the world: automobiles, engines and electronics. The economic renaissance in Japan is unlikely to be without its upsets at the macroeconomic and corporate levels, which would provide numerous opportunities for hedge funds.
 
Commodities remain attractive

Another major theme that will continue to affect hedge funds in 2006 is the developments in the commodities markets. Energy prices are unlikely to return to their previous levels as many hope they will. Thus inflationary pressure is likely to continue, which will have feedback into the commodities sector. This will likely mean price fluctuations, particularly for precious and industrial metals and soft commodities. In dynamic but bumpy markets, commodities hedge funds have certain advantages over traditional, index-oriented strategies as they can also make good use of falling prices.
 
Expected inflationary trends and rising interest rates will create further opportunities for hedge funds in 2006. Rising interest rates usually lead to falling bond prices. Under these conditions, fixed-income arbitrage products can be suitable bond replacements, as their goal is to filter risk from fixed-income products. Convertible arbitrage is also likely to gain more ground. The interplay of different trends and forces between convertible bonds and share prices offers increased price inefficiencies.
 
Interest in hedge funds remains high

Hedge funds will probably assume the role of safe haven in 2006 as bond prices are likely to remain under pressure while equity markets gains are unlikely to be as strong as hoped. Dark clouds gathering on the US economic horizon might affect traditional investment markets.

Increasing consumer debt, rising interest rates and the gradual decline of inflated real estate prices will probably have an increasingly negative affect on US consumers. In view of these uncertainties, which could cause global disruptions, some investors will shift positions into broadly diversified fund of hedge funds or multi-strategy/multi-manager hedge funds. These products do not focus on the uncertain course of indices, but instead seek to earn an absolute total return, even in volatile markets.

Appendix: performance and returns from November 2004 to November 2005

Equity performance        
MSCI World Stock Index 1.80%
S&P 500  8.40%
Swiss Performance Index  38.20%
DAX Index  25.90%
Nikkei 225  36.50%
 
Commodities performance 
CRB Commodities Index  8.00%
Brent Crude Oil  21.30%
Natural gas  66.10%
Gold  9.30%
LME Copper  37.20%
 
Bond performance 
Citigroup Global Government Bond Index  -6.30%
Citigroup High Grade Corp. Bond Index  6.20%
 
Hedge fund performance 
HFRI Fund of Fund Index  7.10%
HFRI Convertible Arbitrage Index  -2.40%
HFRI Distressed Securities Index  10.70%
HFRI Equity Hedge Index  10.10%
HFRI Equity Market Neutral Index  6.20%
HFRI Event Driven Index  8.40%
HFRI Macro Index  6.50%
HFRI Merger Arbitrage Index  5.80%
HFRI Relative Value Arbitrage Index  6.20%
CSFB Investable Managed Futures Index  4.70%

   

Background notes: RMF is a leading provider of alternative investment solutions in Europe, specialising in hedge funds, leveraged finance and convertible bonds. RMF is headquartered in Pfäffikon/SZ, Switzerland, and also has offices in London, New York Tokyo and the Bahamas. RMF currently manages over USD 19.4 billion of assets, with approximately USD 16.7 billion invested in fund of hedge fund products. RMF is part of Man Investments, the asset management division of Man Group plc, a FTSE 100 company.
 

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