10 Nov 2009
Hedge funds had a slightly positive month overall with a widening dispersion of returns among strategies, based on whether managers could take advantage of October’s market volatility.
The Chicago Board Options Exchange Volatility Index (VIX), that measures the implied volatility of S&P 500 Index options, began a surge of approximately 30% on October 23 that took the VIX from just over 20 to just over 30, as equity markets took a turn downward in the second half of the month.
October’s US equity gains for many Long/Short managers were concentrated in the industrial, utilities and health sectors, and from shorting financials. Some managers which have had positive returns in recent months have begun to take profits and wind down for the year, while others which have struggled due to their defensive positions earlier in the year continued to actively seek opportunities arising from the market volatility.
Macro data was mixed, with positive earnings momentum in the US and globally, as well as positive GDP growth figures for the third quarter in the US and China , and encouraging PMI numbers for the Eurozone (except the UK which saw its economy shrink by 0.4% in 3Q). On the other hand, PMI numbers in Singapore slipped to 50.2 from a peak of 54.4 in August, personal spending in the US dropped by 0.5%, and US consumer confidence dropped from 73.5% in September to 70.6%, according to the Reuters/University of Michigan Consumer Sentiment Index.
Certain managers in Equity Market Neutral and Relative Value strategies believe that the increase in market volatility may continue and will likely favor securities pickers who perform fundamental analysis. We believe sideways markets are also generally a better environment for arbitraging rather than long-biased, directional approaches.
For example, Merrill Lynch reports that the convertible bond market was down for the first time since January, but Convertible Arbitrage managers had their 11th consecutive month of positive performance as they shifted their focus to arbitraging strategies rather than the long-only-type credit plays that were profitable earlier in the year.
Equity Market Neutral managers also experienced a positive month and their performance relative to other hedge fund strategies improved, since its market neutral profile can give the strategy an advantage over those with higher market correlations when volatility rises. Dedicated Short Bias had its first positive month since February, and was the performance leader with 5.86% for the month, while many Managed Futures managers gave back some of the profits of the previous two months.
The report entitled, Competition and Convergence: The Evolving Landscape for Hedge Funds, indicates that while investment managers have relatively few assets in equity long and short investment portfolios, this segment of the market continues to grow rapidly as firms seek to diversify their business lines and compete with hedge funds. This new competition for assets has pushed some hedge funds into long-only investment strategies and others towards retail distribution. The report suggests that investment managers will become more important to hedge funds as potential partners in product offerings and mergers and acquisitions. Key findings from the study include:
– Growth of Equity Long and Short Investment Strategies Among Investment Managers Expected to Increase – Investment managers’ control of equity long and short investment portfolios is expected to rise from $204 billion to $345 billion by 2012 representing an increase from 19% to 28% of today’s $694 billion marketplace. According to a recent Finadium survey, 65% of investment managers now operate some sort of long and short fund, up from 33% one year ago. Independent hedge funds are also expected to continue to grow and increase their equity long and short portfolios to $810 billion by 2012 as equity markets recover;
– Potential Regulatory Reform Remains a Wild Card – Investment managers view potential regulatory reform as a wild card in driving convergence between themselves and hedge funds. The report indicates that some investment managers advocate working more closely with hedge funds as sub-advisors and potential acquisition targets with the expectation that increased regulation will occur. Without specific regulation, hedge funds will continue to have few legal obligations to disclose fees and practices;
– Hedge Funds Continue to Benefit from Strong Prime Brokerage Relationships – Investment managers have notably different servicing needs than their hedge fund competitors. These organizational requirements have created challenges for investment managers looking to do business with noncustodian prime brokers, to the benefit of hedge funds with strong prime brokerage relationships. While investment managers are becoming more agile in their technology and operations, no party has surmounted the funding obstacles that regulatory and market pressures have put in place; and
– Tri-Party Custodial Relationships May Offer Hedge Funds an Edge – Hedge funds have a wide range of opportunities and challenges to take into consideration when evaluating the strategies of investment managers in the long and short arena. For example, hedge funds should consider tri-party custodial relationships which bring many traits of the asset management industry into their domain. These arrangements allow hedge funds to mitigate their counterparty risk by custodying cash and fully paid for securities with a less leveraged bank custodian, while prime brokerages still hold the fund’s short positions and provide margin financing.
“As investment managers increasingly expand into the equity long and short marketplace, hedge fund managers need to provide their investors with a distinct value proposition that uniquely positions them in the marketplace.” Craig Messinger, managing director of Pershing Prime Services, said, “Exploring new investment strategies, embracing potential merger and acquisition opportunities and offering clients innovative separately managed account solutions are several tactics hedge funds should consider to help continue growing their businesses.”