We fielded a barrage of calls from the press in the immediate aftermath of September 11’s attacks. Typically, they only needed a quotation or two on what the implications were for hedge funds. However, with about 40 mid-month fund returns to go on, our reply was that hedge fund strategies and the managers pursuing them were too heterogeneous in their operations for a generic statement to be relevant; which is the attraction of hedge funds as investment vehicles.
Now that we have the returns for a few hundred funds and the various indices have reported final performance figures for September, the industry in aggregate managed to deal with closed or volatile markets reasonably well. One can be sure that when September 2001 monthly performance is analysed in prospective-investor meetings, the managers who made positive returns will hail it as proof-positive of superior investment skill and risk management. Conversely, managers who lost money will claim they could not be expected to anticipate the attacks and the subsequent dislocations. We suspect the explanation of September’s performance is less bipolar than either group of managers would have us believe, and more likely to be an blend of both in all cases.
This view is based on observations made earlier this year that the returns to many strategies, chiefly equity long/short – general and sector funds, merger arbitrage, and statistical arbitrage had run out of steam. In the immediate aftermath of LTCM, much non-dedicated capital was withdrawn from arbitrage strategies, putting the supply/ demand dynamic back in the hedge funds’ favour. In October 1998, the US Federal Reserve flooded the market with liquidity, which repaired confidence in all financial assets. Inevitably, the competition returned, seeking the profits being captured by hedge funds. Since the start of the year, arbitrageurs found spreads narrow and many equity managers were confounded by rapid sector rotation, as the V-shaped recovery was on, then off, then on again. Consequently, when the terrorists struck, many managers had low gross and net exposures, meaning they were less likely to lose, whatever event occurred.
Since the attribution of realised hedge fund performance is subjective, any attempt to forecast the future carries large estimation errors. In the present environment, ie, overt Federal Reserve Bank interference in the financial economy, bad news arriving daily in the real economy and the psychological effects of anthrax in the US and now elsewhere, any projections will have to be updated. The best place to start looking for clues about future hedge fund performance is to examine factors that have been significant to strategies in the past and see whether or not they are projected to be favourable. For hedge fund believers the whole selling proposition rests on the fact that whatever multi-factor analysis is used to model returns, the best managers can always defy history. This is why we use qualitative and quantitative methods to identify those with real skill.
Equity long/short is the strategy with the largest amount of assets allocated to it, about 47% of all hedge fund assets (source: TASS), and by implication the most interesting to investors. Unfortunately, it is also the strategy that is least tractable in terms of factor analysis because the number of long and short portfolios is vast. The universe of global equities can be sub-divided geographically, by industry, by capitalisation, into growth and value. Any stratification is artificial, but the direction of equity markets has an important bearing on hedge fund returns in aggregate. Therefore a rising market would be beneficial to all but short sellers, but an immediate resumption does not seem likely.

Corporate profits are falling fast, and the earliest estimate of economic recovery is the second quarter of 2002. Even if it comes, and there could be slippage, a lot of firms are running at less than full capacity, so it will be a year before capital utilisation rates rise. Stock markets will be early, but the longer the rise is deferred the greater the chance that hedge funds will fail. We know of a European long/short fund that has liquidated itself this month, not because of large losses, but investors became impatient. We do not expect this fund to be the sole casualty of an extension of the equity bear market.
There is an increased risk of a flight to quality event for every strategy, if anthrax infection rates accelerate or new terror tactics are used. Typically in a crisis, investors sell smaller capitalised companies and buy larger ones that are index constituents. Hedge funds often own the smaller, illiquid companies and sometimes short the large caps. In the worst case both sides of the portfolio would lose money. The major indices are back at pre-attack levels, but they are reluctant to move higher, in spite of low interest rates and abundant liquidity. The 1998 mantra of ‘don’t fight the Fed’ has lost its potency, perhaps temporarily, but it may only be a matter of time before the Fed’s monetary easing efforts are dismissed as ‘pushing on a string’, a fate that befell Japan’s Ministry of Finance.
Merger arbitrage has a small investible universe, since there are only a limited number of deals on which to be long, short or neutral. The number of deals at present is low. Even before September 11, the volume had fallen 50% this year by some estimates. Up to 20 deals broke because of the attacks, and spreads have widened, more deals could break. Consequently, merger arbitrage may look better now superficially, but risk-adjusted that may not be the case. There has been no large-scale withdrawal of capital from deals so the demand side remains out of balance with supply. Deal flow would be improved if cash-rich companies were strategic buyers of competitors when they represent good value. Distressed debt has been this year’s most popular strategy. According to TASS, event-driven strategies including distressed, saw the highest investor inflows in the second quarter of 2001. In a recession there is plenty of distressed paper, but the strategy is subject to interest rate changes and credit risk. Any postponement of the recovery means distressed investors will have to hold higher risk paper for longer, reducing total return.
Each strategy in turn can be examined for risk and opportunities, both of which abound at present for every factor. The factors have a degree of relatedness to one another, but the relationships are not static, which is where managers’ expertise enters the picture. Business risk is always a factor in hedge fund investing and at present investors seem to prefer waiting until there is some resolution of the terrorist threat. That does not mean hedge funds will become marginalised, rather the growth in assets of single strategy funds and funds of funds will be less frantic. Under present circumstances, that is in everyone’s long-term interests.
Owen Brolly, is head of portfolio advisory at Global Fund Analysis

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