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Hedge Funds in Asia

Wednesday, June 02, 2010

Disappearing Act: Where'd the Uncorrelated Alpha Go?

"It is better to fail in originality than to succeed in imitation".

Herman Melville, author (1819-1891)

Preliminary hedge performance numbers for May 2010 are unsettling. And the conclusions are not directed at Asian hedge fund managers alone but can be applied more generally to single managers. I won't even start to include the 'dying breed' of hedge fund of funds (FoHF) here and perhaps investors will start to actually do some homework.

First, so much for absolute returns! Across virtually all asset classes, hedge fund returns are likely to be down around 2.0%-2.5% for May as the combination of swift trend changes in currencies, energy, commodities, fixed income and stocks and to a lesser extent credit negatively impacted many managers. This would be the worst monthly performance number since Nov 2008 and would break a positive performance string of 14 months according to the Credit Suisse-Tremont Hedge Fund Index. Whatever happened to protecting against the downside?

Second, it appears from the early-initial data, that the larger multi-strategy names as well as mega-large, concentrated single strategy funds (e.g. Paulson) suffered particularly badly. We may be seeing the beginnings of a tough time for big-and-unwieldly funds as they try to navigate what may become more volatile market conditions which were augured in with the "flash crash" of early May. They may not be too big to fail, but rather too big to generate performance efficiently and quickly enough. They must rely on economies of scale and big directional bets rather than nimble day-trades.

Third, an increasingly common thread here is the fact that as traditional indices go, so go hedge funds. This was the story of 2008. Back then, after a long trending period in credit, equities, fixed income and commodities hedge funds suffered a similar breakdown heading into the end of 3Q2008. Many hedge fund strategies fell victim to losses partially due to the common complacency investing in crowded trades (banks stocks vs commodities) and that may be happening again. This author recently saw hedge fund strategy level correlations against the MSCI World Index and they were particularly high (see most recent Lipper Hedge Fund Insight Report).

Forth, the dispersion of performance returns appear to be rising for macro and managed futures strategies. By implication then, a falling or static performance dispersion pattern on a month-on-month basis across other strategies suggests a higher correlation among those strategies and so lower diversification for those investors that have little or no weighting to macro and managed futures.

This means that one can expect many hedge fund investors to have suffered steep losses in May. It is important to note there that it is not the absolute level of returns that is important as much as the dispersion of those returns within the specific sub-strategy universe. It is a subtle point.

These general hedge fund insights suggest that the educated hedge fund investor should take even more care in picking a mix of managers by size (being big may be a hindrance) and also by strategy.

The latter point would suggest less of a reliance on multi-strategy approach which might be particularly susceptible to low dispersion and higher correlated returns to its own peer-group as well as to traditional indices. Keep an eye out too for niche macro and managed futures managers, even in Asia, that might be able to weather more volatile market storms that lie ahead. There is still uncorrelated alpha out there. It may be just more difficult to find. Simply keep on looking. Mahalo.