Tuesday, January 19, 2010

2010 Hedge Fund Outlook

For my final letter every year I look back 12 months to see how I fared predicting the year ahead. I always point out that these things are hazardous, and I always open the old newsletter with trepidation. How stupid will I look this time?

Here's what I said a year ago:

Let me start this with something that will sound, on the surface, somewhat shocking: the outlook for hedge funds for the next few years is as favorable as I can imagine. Notice I did not say the outlook for the hedge fund industry, for that’s another matter. No one’s head is in a place, psychologically, where they’re ready to hear this, so the industry as a business will continue to suffer. However, as I ponder what drives hedge fund returns, I can come to no other conclusion than we are entering a multi-year period of 20%-like returns, starting probably after the next redemption cycle is complete at the end of March. Let’s go through the salient points:

1. Market volatility is high, but not crazy-high. Hedge funds like volatility because it causes investors to make sub-optimal decisions which, in turn, create price inefficiencies. Mind you, volatility like October’s – where all security prices are affected indiscriminately - makes it near impossible for anyone to operate. But this is very rare. Plain vanilla high vol is a good thing.

2. Somewhat related to the previous point, market inefficiencies are as glaring as I’ve ever seen. Bonds priced like the whole world’s going bankrupt, munis trading way cheaper than governments…it’s a long list. Understand that it’s not just that prices are cheap, it’s that they don’t make sense, particularly when compared with each other. This contrasts markedly to the generally “efficient” market we saw during the bull market.

3. Borrowing costs are at an all-time low. Almost all hedge funds borrow money to one degree or another. If a fund borrows 1-1 on its portfolio, a two point reduction in margin rates results in a two point improvement in its performance, all other things being equal. Almost no one is pointing this out.

4. The competition has gone ka-blooey (little bit of industry lingo, that). This is the biggest point of all, so just in case you forget points 1 -3, remember this one.

The HFR Composite Hedge Fund Index was up 20.12% for 2009. Johnston sticks it! I was particularly bullish on the mundane arbitrage strategies, and they performed as follows (source: HFR)

Fixed Income Arbitrage 27.4%

Merger Arbitrage 12.0%

Convertible Arbitrage 47.4%

I reprinted this not simply to gloat - although did I mention I stuck it? - but because I believe all these factors are still in place and we are in the middle of an extended hedge fund boom. A performance boom, anyway, because the industry itself is still a shadow of its former self. This is, of course, partly why it’s easier to make money.

Let’s examine the four performance drivers listed above and see how well the thesis holds up going forward.

Volatility has been coming down but it’s still pleasantly high, from a hedge fund perspective:

Hard to see it, but there’s a very recent spike on the right side of the graph.

Market inefficiencies have abated, but only somewhat. Certainly, bond spreads have narrowed dramatically, but spread-based trades remain robust.

Borrowing costs – well, those are certainly still low, aren’t they? No issue there.

The competition argument was, for me, the most powerful, partly because no one was paying attention to it. We were all a bit distracted this time last year, to say the least, but I put forth an argument that over 80% of notional hedge fund assets had disappeared, which took the industry back to mid-1990s levels, at least temporarily. Note that I was including assets from bank prop desks, and many banks ran away from this business over the last year or two. And note also that looking at this notionally – which is the number that really matters – means we were taking deleveraging into account.

Hedge fund assets have received net inflows since the trough a year ago. Bank prop desks (which are basically hedge funds, and used to have twice the capital of hedge funds) are still trying to figure out which way is up. President Obama gave a speech last week that scared the bejesus out of them, suggesting that they not be in the business at all. It’s unlikely that he gets anywhere with this suggestion, but if he does it will be a field day for hedge funds. Getting Goldman Sachs alone out of the competition leaves all sorts of alpha lying around, waiting to be scooped up. (Ironically, Obama’s proposal may be one of the few things he has suggested with which I don’t rabidly disagree.)

All in all, I’d say the argument for a multi-year bull market in hedge fund returns is still intact. This year I’d guess in the 15-18% range.

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