Fund managers forecast favourable conditions in 2005 after a tempestuous 2004 for hedge funds Fund of fund managers have painted a healthier picture for the industry in 2005 after a 2004 that could be described at best as 'trying'.Piers Metcalfe, senior investment executive at Sagitta Asset Management says the falling volatility of 2004 damaged global macro, CTA, short-selling, equity hedge, merger and convertible arbitrage funds. Also, rising interest rates hit CTAs, equity market-neutral as well as convertible and fixed income arbitrage .Tightening credit spreads hurt distressed, convertible and fixed income arbitrage, while trendless markets hit global macro and CTA funds, short sellers and equity hedge.These factors, Metcalfe says, have created "a perfect storm against which strategies have had to battle with varying success. Not one of the factors has been the sole, over-riding reason for this difficult period for hedge funds. The fall in volatility has affected all strategies as hedge funds are inherently long volatility."We feel 2005 will be very different from 2004 and the environment will be better for hedge fund returns."The managers of the Guernsey-registered, London-listed Dexion Absolute Ltd fund of hedge funds (FoHF), note the close of 2004 was typified by the Republican US presidential victory, favourable economic and corporate results, and declining oil prices all fuelling global equity markets.They predict a "return to more robust, fundamentally driven markets that favour [the managers'] research-intensive approach," saysDexion's Robin Bowie."The dollar's continued decline against other currencies is of interest for nearly all of our managers, as its revaluation may have significant impact on the world's equity, fixed-income, and commodity markets in 2005," Dexion adds.Eric Bissonier, chief investment officer (Europe and Asia) at Geneva's EIM, says investors in diversified FoHFs have been frustrated over the past few years by FoHFs' low volatility, "which seems to be linked to rather disappointing performances in the industry.""This frustration has been heightened by the fact that these mediocre performances have been observed in almost every FoHF," Bissonier adds. "From his most tender financial infancy, the investor is immersed in the investment base paradigm: more risk means more return."However, analysis by EIM found by segmenting managers into four groups by returns and volatility between June 2000-June 2002, and monitoring them to June 2004, the groups, according to performance, "did not reproduce their previous achievements"."The least volatile group, which also had the weakest performance of the four volatility groups, still displays the lowest characteristic spread, but only the third-worst performance," Bissonier says."This is not surprising, as generally, the most conservative strategies, such as equity market-neutral or, alternatively, event-driven ones - which have little leverage - will produce very stable but pretty low returns. Over the period, this quartile achieved an annualised return of slightly over 8%."The most volatile quartile of EIM's managers from the first period remained the most volatile in the second period, but these managers were also by far the worst performers with annualised returns of 7%. The middle quartiles returned between 11%-14%."For a fund of funds, where the goal is to increase its volatility, long/short equity strategies and directional strategies (global macro and CTAs) are more likely to be used," Bissonier says. "These strategies are also the most sensitive to market behaviour, and thus have the greatest correlation to the markets, especially share and rate markets."Higher volatility and rate cuts will benefit hedge funds, the London FoHF manager notes, "but we feel convertible arbitrage managers should be reviewed for 2005. Credit spreads may widen and new issuance may occur but, currently, we see no reasons why."Arne Hassel, chief investment officer of Coronation Fund Managers (CFM), concurs convertible arbitrage will be difficult in 2005, but he adds: "even though CFM continues to be underweight (convertible arbitrage) we think that managers with strong trading skills and portfolios which are very long volatility are interesting."Global macro is the most attractive strategy to Sagitta in 2005, but choices should have strict risk and exposure controls. High transparency will help avoid a clustering of trades that affected macro managers' returns in 2004, Metcalfe adds.Hassel adds that he doubts another poorly performing strategy in 2004 - merger arbitrage in its pure form - "will ever re-emerge as a single strategy." Hassel is also somewhat disparaging of statistical arbitrage, where "so many managers are taking advantage of the inefficiencies in this area that the opportunities are drying up."Coronation is positive about Japanese event-driven and equity long/short. Transformations of Japanese industry is creating opportunity for event-driven with the key drivers being pressure on banks to clean up balance sheets, increasing foreign involvement in Japan's markets and law changes allowing foreign investors to use shares to acquire firms more tax effectively.key pointsManagers believe credit spreads could widen and volatility will increase in 2005.However, the dollar's decline is still a major concern for equity, fixed income and CTA funds.Managers are also upbeat about Japan for 2005....
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