| A cold wind chills alternative management |
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| 11/07/2004 | |
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Alternative assets are not fulfilling the promises they made to investors, with hedge funds posting negative returns in June for the third month in a row. The Hedge Fund Research (HFR) Global Index was down 0.2 % in June, after - 0.6 % in May and -1.2 % in April. It's not a done deal yet, but negative returns in July would set a record since this index has never fallen four months in a row. Moreover, the results of the last three months wipe out the gains made in the first quarter. Indeed, the HFRX Global Hedge Fund Index shows a 0.2 % negative return in the first half of the year. Even the HFRX Equal Weighted Strategies Index is down 0.46 % since the beginning of the year, compared to a rise of 1.2 % for the S&P 500. Still, the analysis of hedge fund performances remains somewhat confusing, with so many indexes from various providers. As such, the MSCI Hedge Fund Composite Index (Equal Weighted) is up 1.50 % year to date, compared to 1.43 % for the MSCI World Equity Index. The May data, the last monthly results available, also show losses. Overall, it seems that hedge funds provide good downside protection, but often fail to beat bullish equity. At a time when investors are thinking about, and often actually allocating a larger share of their portfolios to alternative investment, "hedge funds must show they can achieve positive returns under any market conditions", comments Hedge Fund Research. Leverage With American interest rates climbing up and flattening yield curves, leverage and carry trades become expensive and risky. In its last Financial Stability Review, UK's BoE warns that strong growth of hedge fund assets of the last years and the continuous search for excess-return ("alpha"), raise questions about whether such high returns are sustainable. Soon, decreasing returns could find roots in the lower quality of the increasing number of fund managers entering this lucrative market, eventually eroding the stability of the financial system as a whole. "Problems could in principle manifest themselves in two broad ways. One would be a gradual over-accumulation of debt based on mis-pricing of credit risk […]. The other issue has been whether there could be an abrupt asset price correction", writes the BoE. This spillover will likely depend on the extent of the leverage in the system. Already, the BoE says that there are signs that US yield curve carry trades by hedge funds and other short-term traders are unwinding. The movement is still in its inception, but could quickly gain steam. Moreover, issuance of structured notes linked to hedge funds performance has grown. Consequently, fixed income funds and distressed securities strategies, almost the only ones to have churned out positive results in the last months, and for whom leverage is an important part of the business model, could take much flak in the near future. "Compared with 1998, contacts typically suggest that there is now greater risk of stress from many funds tending occasionally to be similarly positioned that from a single large fund failure, perhaps particularly in Europe where many start-up funds are believed to be concentrated in fixed income, currency and commodity markets" says the BoE. Usually lauded for being the best and safest alternative investment vehicles, funds of hedge funds are now under fire, after having become an important vehicle for long-term institutions wishing to invest in alternative asset classes (+30 % in 2003, to $200 bn, see article beside). "Although they vary considerably, taken as a whole they are said increasingly to use leverage, typically by borrowing from investment banks against collateral in the form of their claims on the underlying hedge funds" warns the BoE. "This double gearing is leading to grave concern [...] because the interest rate cycle is turning and fund managers have little certainty about where their alpha will come from" adds the Bank for International Settlements (BIS), which is going to hold its Financial Stability Forum on hedge funds in Washington DC on September 8th and 9th. On the top of this trend, media stories about the third successive month of negative returns of Man Group, one of the world's largest fund of hedge funds managers (near $ 40 bn under management) and the withdrawal of $2,7 bn by Credit Suisse Private Bank, have added oil to the fire and could further dampen speculative enthusiasm for alternative assets. Not so decorrelated? Funds of hedge funds are also criticised for their failure to add value, largely because of high fees. Until recently, funds of funds typically charged a 1 % administration fee and around 10 % of performance fee, that is, a total charge of 2 % for an average year. More sophisticated products can charge even more, up to 4 or 5 %, with extra layers of fees. But funds of funds fees are now forced down and some managers feel complied to give up administration fees, relying instead on their performance sharing threshold, while trying to boost their performance. Supporting this observation, a report by Cesar Molinas and Altynay Davletova, Strategy analysts at Merrill Lynch, concludes that "in aggregate funds of funds fail to show significant alphas both in any period, bull and bear market, reflecting either the burden of the double fee structure or the difficulty in putting together a portfolio of hedge funds that shows persistent positive performance over time, or both reasons simultaneously". Merrill Lynch's analysts also looked at single manager hedge funds. "On aggregate, they did not add value above the fees they charge during the years of the equity bull market to august 2000, but had outperformed during the bear market since September 2000". Furthermore, Merrill Lynch's report demonstrates that the continuous poor performance of hedge funds seems to be more consistent than their positive performance. Merrill Lynch's analysts also cast doubt on the diversification benefits of alternative investments. In fact, looking at 25 different hedge funds strategies, they find that only half of them saw their correlation with equity fall substantially during the bear market period. Along the same line, Mercer Investment Consulting said recently that the correlation of the CSFB/Tremont Hedge Fund Index with the FTSE World Index is 0,5, but 0,7 in severe market sell-off. Hot debate In this rather shaky context, regulators are trying to stay "ahead of the curve". Hedge funds are closely monitored by the US SEC first, and by the BIS Financial Stability Forum. William Donaldson, the Chairman of the US Securities and Exchange Commission, is set to decide on July 14th on a compulsory hedge fund registration. However, his regulation project struck a controversial cord in the industry. Even within the SEC itself, there is no consensus: two of the five commissioners are opposed to it, and are supported by Fed chairman Alan Greenspan himself. 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