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Hedge funds in search of alpha growth drivers, says Fitch

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Fitch Ratings says that despite strong returns in September, hedge funds are still struggling to find solid sources of outperformance.

The industry is witnessing a strong comeback of top-down macro-driven markets, affecting confidence, liquidity and volatility, with a high level of correlation across assets.

The quarterly hedge fund newsletter from Fitch also discusses fund of hedge funds consolidation and the lessons investors in hedge funds can draw from recent trendless volatile markets.

The first three quarters of 2010 demonstrated that investment markets remain vulnerable to changes in the global macroeconomic outlook. The initial hopes for gradual normalisation in Q1, as supported by positive company newsflow, gave way to a severe decline in general risk appetite in May-June. Q3 developments are confirming that fears of deflation have not abated and that monetary policy continues to be the most important factor to understand market behaviour.

"Systemic risk has not subsided and continues to hurt directional strategies, especially equities and macro, which are particularly suffering from rising correlation among asset classes and the so-called ‘risk on/risk off’-type of market behaviour," says Olivier Fines, an associate director in Fitch’s EMEA fund and asset manager rating group. "At the same time, relative value and event driven strategies were able to profit from low interest rates, a renewed corporate activity and a broader set of opportunities to exploit inefficiencies in the various sectors of fixed income, yield curves and credit."

Nevertheless, hedge funds as an asset class are becoming better regarded by institutional investors, as several industry surveys have shown many intend to raise the strategic share of hedge fund assets in their allocation, on average.

As early "reallocators" are larger institutions, less inclined to invest through funds of funds, traditional fund of hedge funds do not materially benefit yet. They remain in a difficult situation, even if the massive erosion of their assets and positioning as predicted in 2009, did not materialise and AUM bottomed earlier this year. This is likely to further fuel consolidation in the fund of hedge funds industry.

"A recent renewed interest from acquirers is driving consolidation in the fragmented FoHF industry. However, the poor quality of targets will limit the number of transactions," says Manuel Arrive, a senior director in Fitch’s EMEA fund and asset manager rating group.

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