Why Hedge Funds Might Shine In 2009

High-Quality Funds Will Emerge Stronger From The War Of Attrition.

Hedge fund managers, once the swashbuckling frontiersmen of international finance and subject of fawning cocktail party banter, have quickly gone from hero to goat. As the global credit bubble burst with a vengeance in 2008, so too did the oft-touted myth that these alternative strategies could deliver positive results in any market.

But those claims painted the universe with too broad a brush. There has always been a difference between arbitrage funds that isolated structural inefficiencies, and speculators that either didn't hedge or used the ability to short stock as a means of leveraging directional bets. Clearly it should never have been expected that a fund that was short financials and long commodities, as many hedge funds were last year, would have a market neutral, "absolute return" profile. The majority of North American offerings fall into that camp, so it's no surprise we've seen stark declines among many of our homegrown funds.

To be sure, even many arbitrage funds have been badly stung, and many, many hedge funds will disappear in the next six months as a war of attrition rages. But the ones that survive may just find that the next two years are very good to them.

The Return Of Mispriced Assets

Arbitrage opportunities are the low hanging fruit of modern investing. In their purest form they represent the chance to make risk-free profits because some inefficiency has caused two identical securities to temporarily diverge in price. These opportunities are the bread and butter of most traditional hedge fund strategies.

In the years preceding the current mess, with the size of the hedge fund world expanding apace, as soon as the price of anything broke out of its normal range there was a wave of capital pushing it back in line. The increased competition had killed, or at least badly maimed, the golden goose. That's one of the reasons equity volatility was so muted between 2002 and 2007, despite major events like the Iraq War, Hurricane Katrina, and the $6 billion implosion of hedge fund Amaranth Advisors. It also explains why hedge funds were strapping on more and more leverage: the size of the mispricings had become so small they needed to magnify them artificially, and credit was abundantly available.

Now some of that low hanging fruit is back. With volatility at record levels and desperate hedge funds reversing their trades to get out of them quickly, mispricings are everywhere and those with the means can take their pick of compelling opportunities.

Indiscriminate Selling

With redemption requests flooding the inboxes of hedge funds and mutual funds alike, good names are being dragged down alongside the bad as investors rush for the nearest exits in equities and corporate bonds. While the direction of markets is unpredictable in the near term, it seems reasonable to assume that quality companies will once again be separated from their weaker counterparts. Hedge funds that can buy an industry's leaders and short its likely casualties are poised to benefit from that differentiation, even if a broad-based rally is slow to materialize.

Food For Vultures

The current crisis had its roots in esoteric derivatives that repackaged subprime mortgages. In fact, anything with an acronym -- CLO, CDS, ABCP -- seemed to draw some blame for the ensuing rout. Complex instruments were uniformly scorned and experienced sell-offs of massive proportion.

Invariably the pendulum swings too far in both directions, and as time passes there will likely be tremendous buying opportunities in areas like convertible bonds and asset-backed securities. This is a realm of the market that most pension and mutual funds don't venture into, either because it's not in their mandate or they don't have the analytical resources. Look for a few well-capitalized hedge funds to swoop in for major bargains in some of these complex securities.

There will also be the potential for strategic acquisitions. In financial markets, disaster breeds opportunism, and as large companies and trading operations teeter on the brink of failure there will be self-interested parties ready to scoop them up on very favourable terms. The winners in this game will be those with flexible mandates and access to cash. When Amaranth collapsed in the fall of 2006, J.P. Morgan Chase and hedge fund Citadel Investment Group bought up the fund's entire trading book at distressed prices. More recently, manager John Paulson, whose hedge funds are among a small group that experienced significant gains in 2008, was one of the acquirers of failed Californian bank IndyMac, along with fellow hedgie George Soros.

As many observers have noted, the global hedge fund industry has begun, and will continue, to go through a well-needed shakeout. Lured by hefty paycheques, traders and rocket scientists began opening hedge funds to the point of saturation, with fewer and fewer market opportunities to justify their existence. From the perspective of unitholders, certain structural aspects of the archetypal hedge fund are undesirable, such as high fees and poor disclosure, and these will need to improve as the asset class matures.

Many funds will soon close their doors forever, but those that survive will emerge with increased market share and a renewed chance to make big profits across the spectrum of tradable securities. As high-volume, fast-acting trading entities, hedge funds are still very important prime brokerage clients for the major banks. Having that VIP status, large hedge funds will be among the first to regain the ability to apply leverage and borrow stock.

As the division sets in between the quick and the dead, monitoring the group's results will be harder than ever. Hedge fund index statistics will be unreliable as survivorship bias takes on more and more significance. Even numbers that incorporate fund failures, such as the returns on funds of funds, will, by averaging out the winners and losers, mask the extremes at either end.