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Betting your hedges

22 December 2011 By Richard Beales, Neil Unmack

The improbable must-have holding of 2012 is hedge funds. The typical fund has lost 4 percent this year through November, according to Hedge Fund Research. But that poor performance isn’t deterring institutional investors.

Eleven months into 2011, even the S&P 500 had managed a 1 percent gain including dividends. HFR’s chosen bond index returned nearly 8 percent. The average hedge fund is a loser by comparison.

One problem has been that the superior analysis hedge funds claim to offer has turned out to be almost useless. Government actions – from Europe’s inconclusive gatherings to Washington’s brinkmanship – and knee-jerk reactions by investors have overwhelmed the fundamentals focused on by pickers of stocks and other assets. Ingrained habits, like selling losing positions, have proved disastrous. Some hedge funds have been smart or lucky. Others, including big names like John Paulson, just got the year badly wrong.

More than the usual number of pension fund managers and the like are disappointed with hedge fund performance, according to a Preqin survey. But the number intending to hand over still more money for hedge funds to manage far outweighs those planning to withdraw cash. It’s a bit of a paradox.

The rationale is that they desire yearly returns of, say, 8 percent. Bond yields are low – no more than about 2 percent for safe 10-year government paper – and the prospects for equities dim with developed-world growth anemic at best. Unless these investors lower their expectations, they have little choice but to bet that more rational conditions will return and that hedge funds armed with brains, flexibility and hopefully judicious leverage will again deliver double-digit returns.

For those funds that don’t, there are warning signs. Some 213 of them closed in the third quarter, according to HFR. That’s the most since early 2010, though still far from the 778 shuttered in the fourth quarter of 2008.

Overall, hedgies look well positioned to get a pass for their poor 2011 showing. But while big investors may give them another chance, they shouldn’t be surprised if markets continue to be erratic in 2012 and prized managers again struggle to prove their worth.

Predictions: Breakingviews is publishing a series of articles over the holiday that look ahead to 2012. The pieces will be collected together in the annual ’Predictions Book,’ produced in print and electronic form early in the New Year.

 

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