Fitch Ratings says in its quarterly hedge fund newsletter that the industry has shown resilience in the face of difficult macroeconomic and market factors for the year-to-date.

However, market volatility in May highlighted funds' exposure to systemic risk and affected many strategies, including those focused on fundamental analysis and arbitrage.

Global hedge fund assets under management have benefited from positive inflows so far this year, due to a return to absolute return management from institutional investors looking for yield and asset diversification.

Hedge funds are demonstrating a greater focus on relative value strategies in 2010 compared with last year, when the performance rebound was largely explained by the general direction of equity and credit markets.

"A period of price normalisation and dispersion based on fundamental factors and arbitrage usually follows a general and positive asset revaluation cycle," says Olivier Fines, an associate director in Fitch's EMEA fund and asset manager rating group. "However, Europe's sovereign crisis has affected liquidity and confidence, negatively impacting most strategies, as May returns have shown."

Given that markets continue to be volatile and despite the fact the systemic risk has somewhat retreated, Fitch will monitor how hedge funds, taken as a whole, adjust their gross exposures in the coming weeks.

This year is also demonstrating that systematic quantitative traders are having difficulties in post-2008 market conditions. But beyond the relative lack of mid-term trends, the market also highlights the need for several of these managers to conduct an in-depth review of their investment approach and research new trading models to become more flexible and more broadly diversified across markets.

The performance of funds of hedge funds is still lagging the broad hedge fund indices as they continue to suffer from a lack of flexibility given legacy positions, fund restructuring and caution regarding liquidity. Fitch believes funds of hedge funds will continue to remain a convenient way of accessing alternative investments for small and mid-size investors, provided more resources are put into researching top-down approach and portfolio construction, for better management of liquidity, beta and alpha factors.

Fitch further believes that topics such as regulation, the Ucits EU legislation for alternative investment funds, and consolidation will influence the future shape of HF management and distribution, with increased segmentation of investors (offshore or onshore, distribution or institutional) and players (specialist or generalist, performance provider or solution provider, single product provider or with tailor-making capacity).


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