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Sense of the markets: Tough sledding for hedge funds

by Paula Schaap | Published October 21, 2011 at 10:30 AM

Volatile trading in the third quarter of 2011 wasn't kind to those who make their living hedging the market.

Hedge funds posted the fourth-worst quarterly performance, according to Hedge Fund Research Inc., since the data provider started keeping track in 1990. The HFRI Fund Weighted Composite index was down 6.2% for the quarter and down 5.4% year-to-date.

Performance declines caused industry assets to shrink, bringing global assets under management to $1.97 trillion as of Sept. 30, down 3% from their all-time high of $2.04 trillion in Q2 2011.

Volatility trader Russell Abrams, founder of Titan Capital Group LLC, says volatility could be expected for the rest of the year, at a minimum.

"I expect that some funds will keep risk low," Abrams says. "Others will be under pressure because of expected future redemptions, so they might become more aggressive, which could lead to greater volatility."

While net asset inflows in the third quarter slowed substantially -- down 71% from the second quarter to $8.7 billion -- hedge funds have attracted $70.1 billion in investor allocations so far in 2011. Inflows to hedge funds are already up 26% from total allocations to the asset class made during all of 2010.

That also makes sense to Abrams given the volatility reflected in the markets.

"Lots of funds are down double-digits or up double-digits, which could lead to funds both being allocated and redeemed," he says.

Specific strategy indices for the third quarter bear Abrams out. The HFRI Short Bias index far and away led the field, up 12.44% (year-to-date +5.93%). Quantitative strategies did poorly, however, exactly what might be expected when different types of securities are highly correlated, as those strategies rely on price differentials between different types of securities for returns. The HFRI Quantitative Directional index was down 11.41% in the third quarter and down 9.54% year-to-date.

With uncertainty roiling the marketplace and debt-raising still difficult, funds making their living off of whether deals get done have also struggled. The HFRI Merger Arbitrage index was down 0.78% in September and -0.20% year-to-date.

Yet merger-arbitrage manager Steven Gerbel, of Chicago Capital Management, points to the two big energy acquisitions announced Oct. 17 -- Kinder Morgan Inc.'s whopping $38 billion bid for El Paso Corp. and Norway's Statoil ASA's $4.4 billion offer for Brigham Exploration Co.--as evidence that deals are being struck and more will follow.

Gerbel particularly likes the pharmaceutical and financial sectors for further dealmaking and, therefore, more merger-arb opportunities. Regional banks, he says, need to consolidate to meet regulators' higher capitalization requirements and to save on technology, while larger, acquisitive pharmaceutical companies are facing imminent patent expiration dates on their money-making products.

But markets will have to calm down further before dealmaking gets back into full swing, Gerbel predicts. "When markets are volatile, it's too hard to price a deal," he says.

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Tags: arbitrage | hedge funds | Titan Capital Group LLC

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Sense of the markets: Tough sledding for hedge funds

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