Are Hedge funds an antidote in a bear market?

PENSION funds, other institutions and family offices are buying hedge funds hoping that they will perform in a market decline.

The global stock market rally this year surprised the vast majority of investors. Such were the market swings in 2018 and in particular the sharp downturn in the final quarter of last year, that investors are fretting that the sharp rally in the first four months of the year cannot last. Indeed, worries about a renewed trade war caused global markets to slide in the past few days.

Seeking medicine to counter potential losses, pension funds, other institutions and family offices have been raising their allocations to hedge funds. In a survey, JPMorgan found that 32 per cent of institutional respondents expected to increase their overall hedge fund allocation in 2019. This compares with 15 per cent in 2018.

Only 13 per cent of institutions expect to cut their hedge fund positions while 55 per cent said that they plan to maintain current allocations. Institutions and other investors tend to switch into alternative investments such as hedge funds on expectations that their performance is uncorrelated to the stock market i.e. hedge funds are supposed to perform when the market falls.

Hedge Fund Strategies

Hedge funds have a variety of investment strategies, for example equity hedge and market neutral in which they trade “long and short”, i.e. have a portfolio with bull positions in some stocks which they expect to do well and bear positions in others which are forecast to perform badly. Global macro hedge funds trade currencies, bonds and derivatives and there are hedge funds known as commodity trading advisors (CTAs) that concentrate on gold and other commodities.

Similar to conventional funds, investors closely monitor the results of hedge fund managers. But time and time again in volatile markets, a brilliant performance the year previously can easily turn into losses in the following months if the manager’s bets turn sour.

Hedge funds control $3.6 trillion but average fund performance is unimpressive

Prequin, which analyses alternative investment fund data, estimated that 6,050 hedge funds, including 850 in Asia, controlled $3.6 trillion at the end of last year. Many managers who claim that they have contrarian strategies are therefore members of the hedge fund herd.

On an average basis, the performance of hedge funds is unimpressive even though many have huge teams of PhDs and other analysts, highly sophisticated quantitative models and access to top external research and data.

To be sure, the results on average, illustrate that trading in current markets is not only exceedingly difficult, but that many managers do not justify high management and performance fees. Management fees are generally 1 per cent or more and performance fees, at least 20 per cent.

Hedge Fund Research’s HFRI indices show that on average after fees, the funds have struggled this year, albeit rising less than the overall stock market. They have been unimpressive over the past 12 months and the previous three years.

The HFRI Fund Global Hedge Fund index rose by 2.7 per cent from the beginning of January to May 5, lost 2.8 per cent in the previous 12 months and only rose by 2 per cent in past 36 months. The HFRI equity hedge index from the beginning of January to May 5, was up by 5.6 per cent, negative 4 per cent over 12 months and up 3.1 per cent over three years. Year to date the HFRI Macro/CTA index was down by 1 per cent, fell by 1.4 per cent over 12 months and declined by 1.3 per cent in the previous 36 months.

Was it a false breakout for FANGS & other tech shares? If so, they could be experiencing a bear market rally that could again turn into a vicious slide that ultimately tests the NASDAQ’s December lows.

According to Bloomberg’s hedge fund data analysis of 2018, “a chasm has emerged between managers who outperformed, those who saw staggering losses and others that landed somewhere in-between”. Overall, the industry experienced its biggest annual loss in seven years, declining 4.1 per cent on a fund-weighted basis in 2018, according to Hedge Fund Research.

Some managers, including smaller, more nimble traders, successfully navigated the market turbulence in the worst year for the S&P 500 Index since the financial crisis. Those that appreciated by more than 30 per cent were Odey European, Northlander Commodity, Crescat Global Macro, QQQ Capital and Alta Park. But there were several funds that lost 25 per cent or more and many others that experienced downturns.

Hedgeye CEO Keith McCullough predicted the fourth quarter equity downturn but was surprised by the extent of the 2019 bounce. He believes that investors should be wary of emerging markets and that US markets surged in the first four months because “earnings were better than expected”. He fears that markets, especially in Europe, are vulnerable to an “earnings recession” in coming quarters.

Caveat emptor!

© Copyright Neil Behrmann. This article was first published in The Business Times, Singapore
Neil Behrmannis London correspondent of The Business Times. Jack of Diamonds his thriller on global diamond mining and smuggling, has recently been published. It is the sequel to the thriller, Trader Jack, The Story of Jack Miner. See reviews of both books on:

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