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Hedgeweek Commentary: Behind the hedge fund news

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Hedge funds may be heading for their worst year on record after suffering another battering in October but the news in not all bad.

Hedge funds may be heading for their worst year on record after suffering another battering in October but the news in not all bad. For a start, there’s no sign that institutional investors are writing off the asset class as a whole, although the performance of individual managers through the market turmoil is inevitably coming under the microscope. Secondly, there is some reason to hope that while the industry seems likely to face additional regulation, scrutiny and transparency requirements, these may be carefully considered and measured rather than hasty and arbitrary. Certainly let’s hope so.

Vanilla – with a little chocolate

In the midst of determining what is the right strategy to implement during these troubled times, hedge fund managers are opting for plain vanilla strategies – but with a sprinkling of chocolate.

Traditional investment options such as long/short equity are again a favourite among fund managers who over the years have tried their hand, and sometimes succeeded, at more complex investment strategies.

But now it’s time to stick to tried and tested methods. According to a survey of asset managers, institutions, and high net worth investors at the Gaim Fund of Funds conference in Geneva, hedge funds using technical indicators or a combination of technical and fundamental indicators to make short or medium-term bets on market movements are likely to fare best in the next two years.

Long/short equity strategies were chosen by 16.7 per cent, while a third of respondents expressed a preference for funds that combine trading, arbitrage and long/short equities strategies.

This year different strategies have enjoyed wildly different fortunes. Greenwich Alternative Investments says that convertible arbitrage strategies suffered a 20 per cent average decline in October and a year-to-date drop of 35.2 per cent. Short-biased funds may have been hampered by temporary short-selling restrictions during part of September and October, but they gained 11 per cent in October and are up 25.6 per cent so far this year.

All this might be turned on its head in 2009, of course. Let’s see what the New Year brings in – but in the meantime, simpler investment models seem to be back in favour.

Investors still like hedge funds

Despite all the moaning from politicians about hedge funds and the negative press coverage they have been receiving over the past few months, they are set to play a greater role in many investors’ portfolios in the years ahead. According to a survey by Morningstar, 25 per cent of financial advisors polled and 30 per cent of institutions expect hedge funds to become somewhat or much more important in the future.

Meanwhile, pension funds are diversifying their assets out of equities and into other investment classes, according to the UK’s National Association of Pension Funds. Among 294 defined benefit funds surveyed with a total of GBP450bn in assets, the proportion of assets invested in equities has fallen from 59.7 per cent in 2006 to 49.9 per cent this year.

As an alternative to equities, pension funds are choosing to diversify into other asset classes, and their investment in hedge funds has more than doubled as a share of total assets, from 1 per cent in 2006 to 1.9 per cent this year.

This seems to augur well for the hedge fund industry, but investors do have concerns they want to see addressed. More than half of the investors surveyed by Morningstar cite lack of liquidity as a reason to hesitate in allocating assets to hedge funds, and both advisors and institutions highlight a lack of transparency and high management and performance fees.

Willingness to address these concerns can help hedge fund managers to capitalise on what appears to be an extensive fund of goodwill and understanding of the benefits that investors can bring to investors’ portfolios. Who know, it might even attract some favourable media coverage.

The power of the spoken word

Many people would agree that discussion is the best way to resolve any conflict. At a time when blame is freely being flung around for the global financial turmoil, hedge fund managers must be glad that they are getting a chance to voice their opinions and listen to others’ concerns with US lawmakers this week.

On Thursday, the House of Representatives’ Oversight and Government Reform Committee will hold a hearing on the regulation of hedge funds and has called upon various top hedge fund managers to answer questions on topics ranging from their pay to influence on the markets.

The hedge fund gurus are likely to include Philip Falcone, Kenneth Griffin, John Paulson, James Simons and George Soros, who will each have several minutes to make opening remarks and then will have to answer questions from the legislators.

Among other topics, the committee plans to ask the managers whether their funds pose systemic risks to the markets because of the size of their trades and the large sums of money they borrow (or used to borrow) from banks.

Hedge fund managers are bracing themselves for a fresh wave of regulatory measures. Less than two months ago they found themselves subject to a range of short-selling bans and other restrictions, many of which are still in force, and they fear closer monitoring as well as the curbing of some trading techniques.

In that environment, the opportunity to give their side of the argument can only be welcome. As UK economist and Nobel Peace Prize winner Norman Angell once said: “It is not the facts which guide the conduct of men, but their opinions about facts; which may be entirely wrong. We can only make them right by discussion.”

Emanuel’s appointment offers reassurance to hedge fund industry

US president-elect Barack Obama has asked Rahm Emanuel, a one-time aide in the Clinton White House, to be his chief of staff – a choice that is likely to reassure hedge fund managers, even though the Illinois congressman’s relationship with the alternative industry is far from that of an unalloyed cheerleader.

Emanuel, whose career has also included investment banking with Wasserstein Perella and a board seat at Freddie Mac, was the top House recipient in the House of Representatives of campaign contributions from hedge funds, private equity firms and the wider securities and investment industry during the 2008 election cycle.

He played a part in derailing efforts last year to have carried interest taxed as income rather than capital gains, going so far as to write a memo offering several options on how essentially to preserve the tax advantage. However, he also sponsored a bill that would have prevented hedge fund managers from deferring taxes on offshore compensation.

The appointment of Emanuel suggests that Obama’s presumed hostility to the hedge fund industry may have been exaggerated and that the sector will get a fair hearing as the new administration begins the process of reforming US financial sector regulation. At a time when hedge fund managers feel particularly friendless, it cannot hurt to have someone who understands their business in the heart of the White House.

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