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Hedge funds continuing to normalise, says SEB

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Hedge fund performance, as measured by the HFRX Global Hedge Index denominated in US dollars, shows an upturn so far this year of close to nine per cent, according to a report by SEB.

The same index expressed in euros has risen by about six per cent.

SEB says this upturn is heartening, especially after last year’s difficulties. The stability and liquidity of the market have improved noticeably, and one result is that valuations have continued to climb.

Despite the rebounds that have occurred this year, the price anomalies that arose in connection with last year’s financial crash have not been remedied in their entirety. Instead, various corrections remain in order to revert to a normal situation.

The emergency measures that hedge funds were forced to undertake after last autumn’s financial market drama continue to be phased out. Examples of such measures are limiting withdrawals and dividing up funds so that distributable capital is in one fund and capital that cannot be realised immediately is in another fund.

Various studies show that such assets have steadily decreased during the year, and today they have fallen to around ten per cent of the total or below. This is positive for hedge funds, the report says.

The liquidity of underlying investments has improved substantially. Hedge funds have thus been able to use mark-to-market valuations of their holdings instead of employing the “prudence principle” prescribed in accounting rules. This has helped hedge funds achieve good price performance this year. Today most such corrections have been carried out, but not all.

Surveys also indicate that flows of hedge fund assets have again turned positive. The first signals of this change came in April and May, and since then the situation has slowly improved.

Since spring, equity long/short funds have shifted their focus from what can be characterised as quality investments and have targeted somewhat lower quality as a way of trying to generate higher returns. Part of the picture is that the net exposure of equity L/S funds has moved from well below historical averages to about average. It thus seems as if managers have regained their self-confidence.

The report says that competitors of hedge funds are slowly returning to the market, to the extent that some banks have started hiring more people for their trading departments.

Before the crisis, there was incredibly heavy competition for good business transactions, hedge fund capital was twice as large as today and banks still had high trading activity.
Today there is considerably less competition, which improves the opportunities for hedge funds to generate value. All else being equal, this should give hedge funds a couple of really good years ahead.

The report also says that while listings in tax havens and long lock-up periods have been widespread for many years, today simpler fund regulations seem to be gaining ground. The trend towards being more liquid and transparent has only just begun, and SEB expects to see considerably more of this in the next few years.

During and after the financial crisis, various demands for regulation of the hedge fund market have been issued by prominent politicians in many countries and of many ideological persuasions. A likely trend towards a more regulated market is thus another factor to take into account. This will be a race against time: whether this will occur via self-regulation − with the hedge fund market reforming itself − or whether it will occur by means of legislation. There are many indications that the outcome will be a combination, says SEB.

SEB has a positive view of equity long/short, fixed income and macro. It is still more reserved about distressed and event driven strategies.

Within equity L/S strategies, it is positive towards all sub-segments. Factors to take into account are what proportion of beta or market return it gets. Certain portions of emerging markets still have terms and conditions that make it difficult to hedge against downturns. Another factor to bear in mind is assessments of how different currencies will perform.

Within fixed income, it is positive towards credit L/S and directional plays, but cautious about relative value for the time being. As for distressed strategies, SEB is especially positive towards L/S, while we are holding off on investing in long positions.

Event Driven strategies do not stand out either positively or negatively, which means that SEB has a wait-and-see attitude. As for macro, it is positive towards both CTA and global macro. CTA strategies have had a little tougher time this year compared to their successful 2008, but as markets stabilise further and trends become established, they will increasingly come into play. As for global macro strategies, the skill of the manager determines the return to an even greater degree. Properly handled, they offer fine opportunities to generate good returns in relation to risk, SEB says.

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