Not being dragged by a hedge backwards

Hedge funds are unregulated investment vehicles pursuing a multitude of strategies that aim to exploit inefficiencies or anomalies in the markets.

They set out to achieve a profit regardless of the direction of the equity or other markets. Although often treated as an asset class by investors, hedge funds in fact trade traditional asset classes, while benefiting from less constrained investment mandates and the ability to vary their market exposure through the use of leverage, derivatives and short selling - and more recently deleveraging in order to protect investors' capital.

They have grown in popularity dramatically in the last 10 years as investors flocked towards the industry in an attempt to capture their superior risk-adjusted returns and capital preservation features.

Until 2008, hedge funds had produced very attractive, generally uncorrelated returns and effectively protected capital through various market crises. They emerged successfully in positive territory after the three-year bear market that followed the technology bubble burst in 2000. Unfortunately, this year has been another story. As the sub-prime crisis spread throughout the financial industry, hedge funds found there was nowhere to hide and produced negative results in the 12 months to the end of September, albeit still performing better than equities.

A fair criticism is that there has been increasingly high correlation between the hedge fund strategies themselves, removing some of their diversification benefits. Hedge funds have continued to show some capital preservation characteristics in comparison to their traditional counterparts. However in recent months they have failed to generate the uncorrelated, absolute returns investors had expected. The impact of liquidity in this crisis meant that many hedges put in place to protect portfolios did not work as intended and in some cases hedge funds, along with many investors, have been caught out by artificial market movements caused by political intervention. So the question arises as to where to invest?

An extreme flight to safety by investors caused treasury bills to rally to such an extent as to offer a negative real yield. They are an apparent safe investment in the short term, but as the world starts to emerge from this crisis investors will be looking for ways to put capital back to work and the volatility seen in traditional markets is exactly what many are trying to avoid. Investors are understandably wary of hedge funds given how 2008 performance has deviated so violently from previous trends. Short sellers in particular, have come under fire recently for driving financial stocks into failure. Short sellers can not be wholly blamed for this crisis but they certainly had their part to play. For now, short selling of financials is prohibited by most regulators and although this is a temporary ban it is reasonable to expect increased regulation and disclosure requirements in the future.