Hedge funds will ride the storm
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What is it about October and financial markets? While Mark Twain famously suggested that all months were dangerous for speculators, there does seem to be particular ‘seasonality risk’ to October, fuelled in the popular psyche by the events of October 1987.
This year, equity markets, bond markets and energy and commodities markets all slumped during the month, pressuring equity managers, bond-fund managers and specialist managers respectively. Fears that hedge funds were especially hard hit are, however, likely to be – as always – somewhat wide of the mark. “Is October becoming a seasonal disaster month for hedge funds?” asks HedgeFund.net’s anonymous market prognosticator, ‘The Shadow’.
The conclusion, notwithstanding a poor showing for most strategies for the month, is probably not. Perennial fears over hedge-fund performance reflect the ludicrous mystique that has grown up around the sector. Investors have been sold the illusion – helped by media hype – that hedge-fund prices only ever rise. But as any true investor knows, there is risk in all markets. Components of market, sector or stock-specific risk can be ‘hedged’, but in the process of genuine hedging, compression of returns is all but inevitable. As a result, many hedge-fund managers use leverage (borrowed money) to boost otherwise marginal returns. But when interest rates rise, as they did this October in the US, leverage also exerts a malign influence on investment performance.
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October undoubtedly represented one of those ‘perfect storms’ that assault financial markets from time to time. Simultaneously, all major equity indices fell and bond yields rose, as markets nervously awaited news of Alan Greenspan’s replacement at the US Federal Reserve and fretted about the inflationary impact of higher energy prices earlier in the year. Ironically, surging energy and commodities prices then also went into reverse. The collapse of Refco, a brokerage business with widespread links to the hedge-fund community, did nothing to assuage the fear and confusion.
But the concern over systemic crisis is probably overdone. Hedge funds have had a tough year, but year-to-date most strategies remain in positive territory. Of the six benchmark hedge-fund strategies tracked by Dow Jones, only one – convertible arbitrage – is in negative territory for the year (-5.0%). The rest – merger arbitrage, event driven, distressed, equity-market neutral and US equity long/short – are all showing anything from flat returns to gains of roughly 5%. This is hardly a stunning showing, but then these are index returns – and many managers will comfortably have delivered double-digit returns, even after fees.
‘The Shadow’ injects some sanity into otherwise fervid markets: “[The hedge-fund space] is only suffering growing pains that all markets endure when too many participants try to do the same things and all at the same time. Truly good managers will separate themselves from their competition in the months ahead. Market history is replete with examples of markets maturing, where the proverbial ‘low-hanging fruit’ disappears from the trees and true talent emerges as the exception, not the rule.” ‘The Shadow’ then helps to lay a few myths when it comes to the apparent easiness of hedge-fund investing. It isn’t easy, and it doesn’t all come down to savvy marketing. The due diligence done on specialist managers is crucial and cannot be circumvented. Dumb money allocated to flimsy chancers will continue to suffer underperformance, if not catastrophe. But if market crises flare up – and I believe that they will in the near-to-medium term – the best managers will become even more apparent.
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