After Strong Year for Hedge Funds, Investors Return

April 17, 2010

THE NEW YORK TIMES, SATURDAY, APRIL 17, 2010

After Strong Year for Hedge Funds, Investors Return

By PAUL SULLIVAN

WHILE the stock market was surging back last year, so, too,
were hedge funds.

This recovery may anger the average investor who equates
hedge funds with the bad deeds of Wall Street. And the funds’
quick return may surprise sophisticated investors who are still
smarting from the money they lost in their rush to move their
portfolios to cash.

But in its most recent report, BarclayHedge, which tracks
the flow through hedge funds, said 2009 was the best year
for the industry’s performance against the Standard & Poor’s
500-stock index since the company started tracking this in
2000.

As a result, money has started to return to hedge funds,
particularly into those focused on distressed debt, fixed-
income and so-called event-driven strategies where a manager
takes a position in a company because he believes its situation
is about to change. In February, investors put $16.6 billion
into hedge funds, according to BarclayHedge. Assets in the
industry as of the end of February stand at a 16-month high
of $1.5 trillion.

“After it’s all said and done, hedge funds did outperform the
broader stock indices in 2008,” said Sol Waksman, president
of BarclayHedge. “As bad as the losses were, they were much
worse in the broader stock markets.”

An even more optimistic prediction by Deutsche Bank’s
Alternative Investment Survey estimated that $222 billion
would be invested in hedge funds this year. Mr. Waksman
said he believed this was overly rosy. “It’s a record-setting
number,” he said. “I hope they’re right.”

Even if Deutsche is wrong, the point is that interest in
hedge funds appears to be picking up again. So will this time
be different? Are investors who are returning now chasing
something that has already passed? Here are some of the
crucial points to consider:

WAS IT REALLY LIQUIDITY?

At the nadir of the credit crash, the rap against hedge funds
was that they used their gating provisions to prevent investors
from pulling their money out. In some cases, this increased
investors’ losses, because they ended up selling other securities
to get cash.

In reality, provisions surrounding when and how investors
could withdraw their money had been clearly stated in hedge
fund documents. The hasty sales were driven by the fear that
the entire system was going to collapse.

 What happened 18 months ago is not going to change how
top managers allow their investors to pull out their money,
advisers say. Hedge funds will continue to require investments
to be locked up, particularly the top-performing funds. That
means people need to accept quarterly, semiannual or yearlong
lockups.

“If you want to invest with the best managers, you have to live
with their rules,” said Martin Gross, president of Sandalwood
Securities, a fund that invests in hedge funds focused on debt.
“Some people get this and want to be invested with that great
manager. Others are very nervous about locking their money
up.”

He pointed out that a lack of liquidity forces people to stick
with their investment strategy. The bad news is that those who
filed forms to redeem their money at the end of March 2009
missed out on the rally.

A liquidity budget may be the better option. This is
essentially an assessment of how much money you can stand
to have out of reach and how much money you need to keep
liquid. Investors with those budgets would have been able to
set aside a safe amount of money and allow the hedge fund
strategies to play out.

NOTHING GOES UP FOREVER

On the whole, hedge funds were down 18 to 19 percent at
the end of 2008. This shook up some people, even though the
broader market indexes were down as much as 40 percent.

“Clients fall into two groups,” said David Bailin, global
head of managed investments at Citi Private Bank. “The ones
who believed in absolute returns — that hedge funds will
never go down — are shell-shocked and gone. The second
group did the tough analysis.”

By this he means they looked at hedge funds for their
relative returns. And those who stuck with that strategy have
been rewarded. Mr. Bailin said 75 percent of the funds his
group worked with were at or above their Jan. 1, 2008, high-
water marks.

A DEEPER DIVE

Hindsight may be 20/20, but there is something to be
learned from how managers positioned their portfolios in
the downturn. David Donabedian, chief investment officer at
Atlantic Trust, which manages $16 billion, said the downturn
had allowed him to differentiate between hedge funds with
solid strategies and those driven by the momentum of the bull
market.

“There is now a track record for how the industry performed
from October 2007 to March 2009,” he said. “You can look
at how they protected assets: were they market-timing or did
they do it through security selection?”

It is also worthwhile to do due diligence — the buzz phrase
since Bernard L. Madoff’s Ponzi scheme was revealed. While
all investors want to understand how the hedge fund intends
to make money, the savvier ones are performing what Robert
Frey, a former managing director at Renaissance Technologies,
one of the top hedge funds, called “operational due diligence.”

In addition to asking how the black box investing strategy
works, investors should also want to know how the firm does
business.

“People didn’t ask about it before,” Mr. Frey said. “Now they
want to know the process. They want to see the details. They
want to know how to avoid the next Madoff.”

WHAT NEXT?

But human nature being what it is, investors also want
to know the next hot areas. Three strategies appear to be
particularly popular.

The first is long-short equity, which allows a manager to
bet against a stock he does not like. “Good companies and bad
companies have come back together,” Mr. Bailin said. “We
need someone who is going to do fundamental analysis.”
The second area is emerging markets, because investors
want to have more options than simply purchasing stocks and
bonds in a particular region. The third is distressed debt, which
gained added relevance after the credit squeeze. Mr. Bailin
said it could provide as much as a 20 percent annual return for
the next few years.

Yet beyond finding the next hot strategy, there has also been
a move to rethink what a hedge fund should be used for: Is it
to get outsize returns, or to preserve capital regardless of what
happens in the broader markets?

Mr. Frey said he had preservation of capital in mind when
he started the Frey Multi-Strategy Fund in February. “I’m
not worried about a double-dip recession, but a low-growth
world,” he said. And in that world, the more circumspect
strategy may suit investors who were burned.

Michael Sonnenfeldt, who made his money as a real estate
developer and investor, said he had maintained his allocations
in hedge funds, but he had become choosier.

“If you’re in an elevator and it drops 20 floors and you
survive, you’ll never get into an elevator again without
remembering that,” Mr. Sonnenfeldt said. He is the president
of Tiger 21, a learning group for high-net-worth investors.

“Our members suffered unexpected, unpredicted losses that
their economic life couldn’t prepare them for. They’re pawing
their way back into risky investments.”

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