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What's best for the recovery - shares or hedge funds?

Deutsche Bank provides its perspective on hedge fund investing in the current market environment.

Tuesday, October 16th 2001, 10:04AM

The uncertainty in today's financial markets has caused investors to review their portfolios, in particular their asset allocation, focusing on how they should react to the recent shift in asset values. We believe portfolios of hedge funds have performed exceptionally this year compared with the equity markets and now look very attractive going forward with respect to bond yields as well. However, many investors are looking at their asset allocation options and wondering if they would not be better off buying into the equity markets after the recent sharp sell-off rather than investing in hedge funds.

Let’s first take a look at how hedge funds have performed during the month of September to understand how a sharp downturn in equities and a negative credit event impacts hedge funds. The overall result is that while many strategies in the hedge fund universe have been adversely impacted, others have actually benefited from the recent market developments. Broadly diversified funds of hedge funds are generally down less than 1% for the month of September while global equity benchmarks (such as the MSCI World) are down over 10%. For the year, broadly diversified portfolios of hedge funds are typically up over 5% while equity markets are down anywhere from 15% to 35%. Although past performance is not an indication of future results, investors are witnessing that hedge fund portfolios can perform well during down equity markets based on both this year’s performance as well as last year's results.

However, the question today is a different one. Since equity markets have been beaten down over the past 18 months, is an investor better off owning equities rather than hedge funds should equity markets rally? There are two approaches to evaluating this question. One approach to this question is the debate of whether equity markets are apt to rally in the near term. The second approach is to understand that if markets do rally, portfolios of hedge funds should also benefit from a market upturn, and will provide a portion of the returns that would have been achieved through a direct equity investment.

To address whether equity markets will rally after the recent crisis, many investors are citing the strong rebound after the Russian debt crisis of 1998. Markets were hit hard in August 1998 - only to have a very strong recovery in November and December - and ended the year up very strongly around the world. The S&P 500 finished up over 28% in 1998. It is essential to highlight that there is a big difference between 1998 and today. In 1998 we were in a bull market and the economy was still growing at a very strong pace. The 1998 crisis was more of a financial markets-based crisis as opposed to a consumer and investment crisis that we are experiencing now. Markets today are dealing with the reality of a confirmed US recession and great uncertainty around future corporate earnings. This combination of factors calls into question the viability of a big rebound and a subsequent longer-term rally in equities. Additionally, with geopolitical stability in question it would seem that volatility could increase and the possibility of another sharp market downturn must be considered.

The second point mentioned above is the fact that hedge funds have generally performed well in most markets but particularly well during healthy equity markets. Hedge fund managers have shown an ability to capture some of the upside in equity markets. This can be intuitively explained given the types of investment risks that hedge fund managers take. In a bull equity market, typically the economy would be growing which would trigger market activity that would be positive for hedge funds. For instance, these positive developments would include merger and acquisition activity that would fuel merger funds, narrowing credit spreads that would benefit convertible bond managers and distressed funds, and improved opportunities for long/short equity managers who have shown in the past the ability to capture equity market upward movement.

To conclude, we believe hedge funds can provide an excellent platform for capturing value that exists through unconstrained investing regardless of the equity market environment. Many broadly diversified funds have performed well during the difficult times this month and the past eighteen months overall. They have most importantly provided steady absolute returns with low volatility. Given the uncertainty surrounding equity markets (corporate earnings in particular), and the possibility of more volatile market events in the medium term, we believe hedge funds remain an essential component of an investment portfolio for capturing returns in the short and long term.

This research has been written and provided by Deutsche Bank.
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