Comment: Where to find opportunities in 2006

Dean Barr, Head of Liquid Investments at Citigroup Alternative Investments, looks at the prospects for the year ahead, and outlines areas of opportunity.

For some, 2005 represented a continuation of the low return, low-volatility environment that began in 2004 for hedge funds. The HFR indices showed that the average hedge fund was up 9.3% for 2005. Less still were the funds of hedge funds, which returned 7.5%. Is this what we should expect from these type of investments going forward? Is it the end of the growth phase for hedge funds and funds of hedge funds?

According to a recent survey, hedged assets reached a staggering USD 1,280 billion in 2005. This happened despite low historical returns, one-off scandals, funds of hedge funds redemptions and increased regulatory scrutiny. While it is convenient to suggest that hedged asset returns still outperformed traditional stock or bond indices, there are very powerful demographic and demand driven trends that decidedly point to continued growth and allocation toward hedged assets. In fact, by some studies, it is not unreasonable to expect a doubling of hedged assets by 2010 to USD 2,500 billion, representing a compounded 15% growth rate over the next 5 years.

We believe the hedge fund industry is in the early stages of a powerful move toward more calculated allocation of risk exposure and leverage to meet future liabilities. This is true for institutions as well as individuals. The result of this pursuit is the recognition that beta is cheap and alpha is rare, and while hedged asset returns have compressed compared with libor benchmarks, the perception, and in most cases the reality, is that hedge funds represent the closest representation of pure alpha. As such, both institutions and individuals will pay for alpha, despite the often-mentioned complaint that fees are too high. For some funds of hedge funds which package hedge fund managers and are therefore an indirect delivery vehicle of alpha, fees will likely come down. For direct hedge funds and other fund of funds that are able to demonstrate real value and differentiation, fees will stay constant and maybe even increase.

Funds of hedge funds

What has happened to funds of hedge funds? There are the likely suspects of over-adoption in combination with too much money, but the short answer is that funds are being forced to evolve, either willingly or unwillingly. It is interesting to look back at where funds of hedge funds made most of their steady, low-teens returns over the last decade, excluding the last two years. What you will find is that many, now large, funds of hedge funds rightly over-allocated to strategies that rely on spread-convergence or relative value strategies to generate the bulk or their return.

Strategies like merger arbitrage, convertible arbitrage and relative value fixed income delivered very consistent returns, and as a consequence, many funds poured billions of dollars into these strategies. We know the story, but many of these strategies have a finite capacity. Over-allocation resulted in compression of the all important spread and may have actually driven down volatility overall (subject of discussion at a later date). The large size also forced many funds to over-diversify into too many hedge funds with the same inherent trades. There is such a thing as appropriate diversification and surprisingly it takes less assets or managers than most think to achieve proper diversification.

Funds of hedge funds returns reverted to libor for those that relied predominately on these staple of strategies. It is also noteworthy that some funds of hedge funds, like our own fund of hedge funds, recognized this trend early on and moved into the world of event-driven and directional strategies. This has made all the difference. Other funds of hedge funds also recognized that too much diversification and over reliance on spread convergence strategies would be problematic and adjusted accordingly, generating superior returns. A word of caution though: Some funds of hedge funds are more adept at choosing managers in the directional space than others. For many, it is an uncomfortable place.

Multi-strategy hedge funds

Obviously, the disappointing returns of some large funds of hedge funds is also giving rise to multi-strategy hedge funds. These funds' implicit diversification of strategies, lower fees, and their ability to conduct near-real time allocation to strategies that provide opportunity and away from strategies that show little chance of near-term performance is very compelling. The development of our own large-scale, multi-strategy platform is a direct result of this trend.

Another powerful force at work driving assets into multi-strategy funds is the recognition that attractive investment opportunities quickly dissipate. The ability to ruthlessly move capital around in real-time toward these quick shelf-life trading ideas gives multi-strategy firms a real advantage over single strategy hedge funds and funds of hedge funds with significant manager lock-up provisions. Many professionals knew that convertible arbitrage was in trouble in late 2003, but were unable to do anything about it due to lock-ups with convertible managers.

The potential for consistent returns from multi-strategy funds stems from the diversity and ability to allocate in real time where opportunities exist globally and across all asset classes. Importantly, multi-strategy funds can choose to react or not react to significant market dislocations and market contagion events that are increasingly common place in financial markets.

The year ahead

For 2006, we need to be vigilant for signs of significant market dislocations. We currently live in low volatility, but volatility is mean reverting. We have a new Federal Reserve Board Chairman in Ben Bernanke. His policy views have yet to be felt by the global market place. We point out that while we and the rest of the world have allocated and continue to allocate large pools of capital toward emerging markets, that a de-leveraging caused by an exogenous event in the hedge fund community could be extremely disruptive to emerging markets and their near-term growth history ('be invested, but be aware').

We are also looking for some sign of a credit cycle downturn which, while not currently evident, could provide for some troubling complications in the credit default swap market where the average settlement (paper) is running at 18 days. The exponential growth of this market, combined with the velocity of trading in CDS's, makes a lengthy settlement process a shaky foundation on which to fuel continued growth. Counter-party risk is the issue here and we watch with guarded optimism while this market attempts to clean up their act before someone else forces them to.

Despite all of these concerns, we believe that the prospects are bright for those directional strategies that are operating in the right geographic markets, like Asia and emerging markets. Currency could be exciting this year as trends become more apparent as purchasing power parity relationships between countries adjust. Returns for most hedge funds will continue to be below historical high returns, but will begin to demonstrate true dispersion as volatility begins to increase. It all comes down to choice of risk, manager or market.

Dean Barr, Head of Liquid Investments,
Citigroup Alternative Investments

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