Resurgence of controversial hedge fund strategy

The hedge fund strategy pioneered – and made notorious – by Long Term Capital Management is returning to prominence amid one of its most successful years yet, aided in large part by the massive issuance of bonds by the UK government and other sovereigns.

Fixed-income relative value trading – shunned by investors after the collapse of LTCM in 1998 – has been one of the industry’s few outperformers this year, thanks to massive pricing anomalies caused by fiscal stimulus packages and unconventional central bank monetary policies around the world.

According to Hedge Fund Research, the average relative value fund has returned 5.33 per cent so far this year, compared with just 1.52 per cent from the average hedge fund. Relative value trading involves identifying “inefficient” prices in bonds – typically government bonds – and wagering that the prices will correct over time.

With mainstream hedge fund strategies such as equity long/short and global macro floundering amid volatile markets, relative value funds have seen their inflows increase. The strategy has taken in $10bn (€7.8bn) from investors this year – accounting for close to half of the entire industry’s inflows.

Among the strongest performers so far has been the $550m Barnegat fund, based in New Jersey. The fund, which was set up after the collapse of LTCM and has recently opened to outside investors, returned 6.5 per cent in July and is up 16 per cent so far this year. The $4.5bn London-based Capula, the world’s largest relative value fund, was meanwhile up 6.78 per cent for the year as of the end of July, according to an investor.

As of the end of June, Element Capital, a $1.5bn relative value fund run by Jeffrey Talpins, was up 10.75 per cent. High returns have been driven by government bond markets flush with arbitrage opportunities, managers said.

Bob Treue, Barnegat founder, said the UK gilts market has been particularly attractive. “We made a lot of money out of the UK’s quantitative easing,” said Mr Treue. “In relative terms, the [government] issuance was huge. In terms of pricing, it was the perfect non-economically priced market. That was the promised land for us,” he said.

Other profitable markets have included Japanese and European sovereigns.

Relative value funds have also benefited from a thinning of competition. Prominent relative value hedge funds, such as Platinum Grove and JWM Partners, have shut down, while banks – once big-time players of relative value trades thanks to their deep pockets and ready access to cheap finance – have exited the market en masse.