Gamble of the week: credit-based hedge funds

By Tim Price Apr 23, 2008

Tim Price

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The first quarter of 2008 has been one of the worst for hedge funds ever. While hedge funds are supposed to make hay from volatile markets, the exceptional conditions in the banking sector and the deteriorating health of many financial institutions have caused all sorts of turmoil in equity markets, credit markets and at prime brokers – the banks that allow hedge funds to gear up their investments by lending them money.

With prime brokers nervously reining in lending, hedge funds have been forced to liquidate sizeable positions to “right size” their portfolios, exacerbating the volatility of price movements in many markets. But while much of the bad news has been focused on developments in the credit markets, particularly in mortgage-backed securities, the extent of forced selling has undoubtedly given rise to opportunities for savvier investors.  

The FRM Credit Alpha Fund (FCAP)

Last year, for example, two hedge funds – Lahde Capital and Paulson – made staggering returns from strategies based on shorting subprime indices, and this year there will evidently be money left on the table for bolder managers to pick up, whether from the long side or the short.

FRM – Financial Risk Management Limited – has a good reputation as a manager of funds of hedge funds, currently investing around $14bn on behalf of its institutional and high-net-worth clients. The group, which is based in John Adam Street in the West End of London, operates a number of funds, but one in particular could give investors an opportunity to profit from the turbulence and dislocation currently wreaking havoc in the credit markets.  

FRM Credit Alpha invests in a relatively focused portfolio of credit-based hedge funds, around 14 in total. It invests in both event-driven strategies, which anticipate changes in corporate ownership and structure, and long-short credit strategies, which benefit from buying underpriced debt and shorting overpriced bonds. The fund is listed and trades on the London Stock Exchange with daily dealing. From its inception in April 2007, the fund returned almost 14% over the rest of the year. 

With prime brokerage firms increasingly trigger-happy about restricting credit to their hedge fund clients, and with the prices of corporate debt swinging about wildly given the credit crunch and fears over the housing markets, some credit-based hedge funds have already blown up this year. But the bond markets of the world are huge, and offer a broad opportunity for disciplined managers to make money. This year is likely to be the one that sorts out the men from the boys.

Recommendation: given the woes afflicting the hedge fund sector, a contrarian BUY at 114.5p

Tim Price is Director of Investment at PFP Wealth Management. He also edits The Price Report investment newsletter.

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