The only way is up

Hedge funds lost 19 per cent in 2008, representing the first year in a decade that the asset class did not deliver positive performance, according the Credit Suisse/ Tremont Hedge Fund Index.

The industry experienced unprecedented outflows of US$582 billion in that year, of which US$149 billion was estimated to be a direct result of investor redemptions. Total industry assets are estimated to be US$1.3 trillion as of March 31, 2009.

While the industry continues to experience outflows, a recent study suggested that although assets may keep declining through mid-2009, there are already signs of stabilisation within the space, and it is expected the industry will climb to $2.6 trillion by 2013, driven largely by inflows from pension funds and other institutional investors.

While markets appear to have somewhat stabilised, liquidity remains a concern for many investors and the shape of the hedge fund industry may look somewhat different in the future.

By assets, it is estimated that 17 per cent of funds can currently be classified as impaired, meaning they have either imposed gate provisions, suspended redemptions or side-pocketed assets (see Figure 1).

Signs of stress were also evidenced by the number of fund liquidations experienced in the industry last year.

An estimated 19 per cent of hedge funds liquidated in 2008, which is significantly higher than the average 8 per cent per year that liquidated between 1994 and 2007. (Note that fund liquidations are estimated based on funds no longer reporting to the Credit Suisse/Tremont Hedge Fund database, as of December 31, 2008. Funds may discontinue reporting to the database for reasons other than liquidation.)

Yet while hedge fund liquidation rates have remained relatively stable since 1994, there was rapid growth in the total number of funds entering the industry during this time.

Following the 19 per cent of fund liquidations last year, we expect to see a consolidation of the hedge fund industry in which surviving funds could potentially have an opportunity to generate significant alpha.

While a commitment to hedge funds remains, we also believe investors will increase their focus on liquidity, transparency and cost efficiency. We expect to see a bifurcation of liquidity terms across strategies, such that strategies with few liquidity constraints — that is, long/short equity and global macro — will offer regular liquidity.

Less liquid sectors, such as convertible arbitrage and event-driven strategies will likely be viewed as longer-term, more private equity-like investments going forward (see Figure 2).

Encouragingly, hedge fund returns appear to have stabilised in the first quarter of 2009, finishing up 0.9 per cent as of March 31, compared to the double digit losses sustained in global equity markets. Further, the Credit Suisse/Tremont Hedge Fund Index (Broad Index) gained an additional 1.68 per cent in April.

Overall, despite continued market volatility, hedge funds outperformed traditional equity and bond indices in the first three months of this year while maintaining lower risk levels (see Figure 3).

As illustrated in Figure 4, six of the Broad Index’s 10 sectors posted positive returns through March, with over half of all funds generating positive performance (compared to only 20 per cent in 2008).

Certain strategies, such as convertible arbitrage and global macro, offer particular areas of opportunities and are receiving increased focus from investors.

In a noteworthy role reversal, the convertible arbitrage strategy has gone from being among the worst performers in the Broad Index in 2008, to being the top performer year to date, finishing up 12.58 per cent through April.

This turnaround took place as credit markets began to function again in 2009, following the credit crisis in the fourth quarter of 2008 in which deleveraging and risk aversion became the driving forces of the markets and convertible bonds suffered a severe devaluation.

A number of additional factors are helping position the strategy for recovery:

n hedge fund deleveraging appears to have substantially subsided, and the suspension of redemptions and imposed gate provisions seem to have taken effect, thereby slowing the need for further portfolio-level liquidations;

n a general reduction in the use of leverage;

n the stabilisation of prime brokers’ margin requirements at more normalised levels;

n further value appreciation may also take place if re-hypothecation and use of leverage resumes;

n if equity markets do not recover, convertible bonds could remain out of the money and behave more akin to straight bonds; and

n if equity markets continue to recover, equity sensitivity may return, which could present new opportunities for convertible arbitrage managers to exploit the inefficiencies surrounding share price volatility.

Global macro managers have also piqued increased investor interest, up 2.78 per cent through April after posting six straight months of positive performance.

The sector has historically outperformed equities and other hedge fund strategies in periods following major market dislocations (since inception of the Credit Suisse/ Tremont Hedge Fund Index in 1994), and many investors predict global macro will be the best performing strategy in 2009.

Overall, hedge funds have served as an effective portfolio diversifier during the current and previous financial crises, producing better returns than broad equity markets on both an absolute and risk-adjusted basis over the past 10 years.

Today, a consolidation of the industry seems likely, leaving surviving funds better positioned to capitalise on alpha-generating opportunities.

We anticipate renewed interest in the asset class going forward, likely to be driven by institutional investors.

In the short term, we

anticipate increased attention will be focused on specific sectors, such as global macro and convertible arbitrage.

Oliver Schupp is the New York-based head of Credit Suisse’s Beta Strategies Group, and president of Credit Suisse Tremont Index, LLC.

This article has been prepared for general information only and should not be relied upon in making investment decisions.