Return of liquidity lifts hedge funds

Listed funds of hedge funds are once again attracting investor attention as their performance improves while their shares continue to trade at sharp discounts to their net asset value.

Their positive returns in the first quarter, superior to those of many equity funds, have even converted one-time sceptics.

Recent performance figures suggest suggest hedge funds are stabilising after a torrid 2008 when many were forced to unwind positions, impose lock-ins or even close because of a wave of redemptions and poor returns.

Now, the situation appears rosier. Waning competition from investment banks and private equity firms is allowing funds of hedge funds to find more opportunities. The high gearing they usually employ also helps. And the discounts their share prices stand at to net asset value (NAV) – as high as 40 per cent last year – are narrowing as a result.

“For those with cash, this is the best environment I’ve seen in 25 years – it’s like being in a sweet shop,” says Robin Bowie, chairman of Dexion Capital, the hedge fund manager. “There’s lots of value and little competition.”

But the sustainability of hedge funds’ performance rests on the return of liquidity over a longer period, says Bowie. “If you remove it from the system quickly, the relationship between securities breaks down and hits hedge funds’ short and long positions.”

Long-short funds that trade frequently are proving resilient, particularly those that operate in the credit market.

From January to March, convertible arbitrage – which involves taking long positions in convertible bonds or warrants, hedged with a short position, usually in the underlying stock – has been the best performing strategy, offering a 9.5 per cent return, according to Edhec Business School.

“Credit is where you are seeing the best risk-adjusted returns,” says Ken Kinsey-Quick, manager of Thames River’s Warrior hedge fund.

He reports that more managers are profiting from the surge in the price of investment-grade corporate bonds. Plummeting interest rates and government stimulus efforts are also a boon for macro hedge funds which depend on shifts in economic policies for profits.

And though distressed securities strategies have yet to see a similar resurgence, they will ride higher when corporate default rates peak and liquidity recuperates a bit further, Kinsey-Quick predicts.

“We came into the year with a lot of cash after acquiring a war chest of it in the fourth quarter, but we’re not jumping in boots and all,” he adds.

“We are taking nibbles. We need to see more fundamental evidence that the markets have turned around.”

Listed funds of hedge funds are sought for a variety of reasons. Short-term traders, for example, play the spread in their discounts. Longer-term investors have been lured by listed funds
of hedge funds’ outperformance against equities last year.

“BH Macro provides pure exposure to an excellent global macro strategy which we do not believe is possible to replicate in an open-ended fund,” says Mick Gilligan, partner with the advisory firm Killik & Co.

Share buybacks can also boost trusts’ NAVs. The performance of Dexion Absolute – trading at a discount of 17 per cent in spite of returning more than 25 per cent in the last month – has been helped by such a programme, says Daniel Balabanoff, analyst at Dexion Capital.

However, there is still room for caution. As Randall Goldsmith of Standard & Poor’s points out, investors in funds that suspended redemptions after last year’s liquidity problems may not be “very forgiving”.

“They may limit their new investments to those funds of hedge funds that managed liquidity well during the crisis period,” he says.

Even the slight rebound in returns holds little appeal for wary investors watching over eroded stock portfolios.

Fearful of widening discounts, Gilligan encourages those seeking steady, low volatility returns to instead seek out Ucits III absolute return long-short equity funds – dubbed “hedge funds lite”.

He suggests BlackRock’s UK Absolute Alpha and Cazenove’s UK Target Return.

“These two funds have had hiccups in performance in the last 12 months – they were down 6 to 9 per cent peak to trough. If this had happened in a listed vehicle, the associated discount widening could easily have doubled the loss,” Gilligan warns.

However, the consensus among many advisers is that funds of hedge funds show promise at a time when the alternatives are few and far between.

“In an environment where the interest earned by savers is minimal, we would be
surprised if money does
not begin to flow back
into funds of hedge funds,
if the positive absolute returns achieved in the first quarter of the year are sustained,” concludes Goldsmith of S&P.