Funds of hedge funds in 2009 and beyond

Although traumatic, the credit crisis has had the beneficial effect of removing from the field many funds that, far from being hedged, were in fact high-risk strategies amplified by leverage. Funds that are properly risk-managed, usually those that are well-established and have conservative strategies, have weathered the crisis remarkably well, certainly relative to other asset classes.

Regulation

The turbulence of the past 18 months has increased demands for oversight. The main thrust of proposed regulatory changes in the hedge fund sector is to ensure greater transparency and restrictions on the use of leverage.

While these changes are probably 18 months away, and will be much altered and improved by various stakeholders in that time, they should be welcomed in an environment in which alternative investments have become a mainstream asset class. It is indicative that the cautious and risk-averse funds of hedge funds that survived the crisis without excessive drawdowns, redemption restrictions or liquidity problems have tended to be those that focus on single managers following the more transparent and ungeared strategies. We believe these funds will be relatively unaffected by the proposals.

Short-selling

At the height of the crisis much press and regulatory heat was directed towards short sellers. However, it is now generally recognised that short sellers play an important role in creating more efficient markets and ensure quick price discovery of securities. For example, the Church Commissioners, previously hostile to the strategy, have now declared against proposed over-regulation.

In a statement issued in September jointly with five other leading charitable foundations, they expressed concerns that proposed regulation “will significantly restrict our ability to generate funds to pursue our charitable missions and thus reduce our impact for public good”.

Fraud

Fraudulent managers are often exposed during a crisis since their imaginary returns are no longer supported by a rising market. Generally, however, fraud succeeds because investors prefer to believe in returns that are ‘too good to be true’. Frauds that have recently been discovered such as Madoff and Stanford have brought to prominence vital, if unglamorous, areas such as operational due diligence controls.

Fund of hedge funds managers who focus on downside risk build their portfolios by combining strategies and risk profiles to inoculate themselves against these dangers. Stenham’s robust operational due diligence process has averted blow ups in its funds over the past 15 years.

Opportunity

Together with the disappearance of many unhedged ‘hedge funds’, the credit crisis has seen the withdrawal of bank proprietary trading desks and the removal of easy credit facilities. Hedge fund assets in the market have halved from approximately US$2trn (£1.21trn) in 2007 to $1trn at the beginning of 2009. Leverage has come down from around an average of 5x to around an average of 2x, representing an 80% drop from $10trn to $2trn invested.

As a result, far less capital is pursuing opportunities not seen for 20 years. For example, in the Merger Arbitrage space and before the crisis, competition from fast-money hedge funds had closed spreads to approximately 5% to 6% annualised, requiring leverage to generate returns. The present less-crowded market has seen spreads widen to around 15% to 20% annualised, which allows far better risk-weighted opportunities for investors still in the market.

Flight to quality

The focus on liquidity, risk management and transparency, brought about by poor performance and regulatory attention, has encouraged investors to move towards quality managers with robust institutional controls. An example of this is the high-quality global macro houses with long track records that have become exceptionally well-resourced investment institutions. Such firms have consistently delivered returns in excess of 15% in all market conditions, even returning positive results in 2008.

Stenham’s investment style

Stenham’s experience over the last 20 years has shown that in the period after a crisis good hedge fund managers have delivered exceptional returns. Given the extent of this crisis we believe that certain more liquid strategies will deliver strong returns and because of the opportunities available, deliver these returns with less risk.

Stenham’s investment style is

conservative with a focus on capital preservation and minimising downside risk. We aim to achieve consistent absolute returns with low volatility through a combination of active strategy allocation and skilful manager selection. Our investment process has evolved over the last 20 years to be as much about managing risk as delivering returns. The performance of our flagship fund of hedge fund, Stenham Universal, demonstrates that it is possible to achieve this objective both in the recent past but also over the long term.

Looking forward

The significant withdrawal of capital from the industry and many hedge funds going out of business has left the sector with fewer participants and a much higher concentration of the brightest investment talent looking to capitalise on market dislocations, which are easier to identify and less crowded to trade. Generating strong returns will be possible, while taking less risk than was seen as necessary by many managers before this crisis. This is a fundamental evolution of the hedge fund industry, the result of which will leave it bearing many similarities to the industry we were drawn to over 20 years ago.