Chris Jones, CIO at Key Asset Management, paints a positive picture of the hedge fund space today, and highlights which strategies are likely to DO well in the current economic environment

Despite the turmoil in the Middle East, the recent devastation in Japan and the ongoing macroeconomic turbulence, there are reasons to be positive on most hedge fund strategies going forward, and more so than any point in the
last 12-18 months.

Hedge funds have a love/hate relationship with large exogenous or top-down events. Although it is always more difficult for a hedge fund manager to control portfolio volatility in turbulent times, the resulting dislocations in asset prices can generate significant opportunities post-event in the short and medium-term.

For example, when equity owners panic-sell stocks due to some market shock, both good quality stocks and poor quality stocks are sold down indiscriminately, thus allowing fundamentally-driven hedge funds to buy severely under priced high quality equities and cherry-pick short positions in weak equities that are yet to suffer to the full extent.

To this extent, hedge funds do not only generate good returns after such turbulence but also act as an analytical ‘voice of reason’ in markets that helps bring them back to an efficient state. Importantly, however, hedge funds do not need a recovery in market direction to generate returns, just a return to normality.

Reasons to be cheerful
Given the above, there is a considerable opportunity set for hedge funds at present. Furthermore, we believe that this opportunity set can be converted to particularly attractive returns this year, much more so than last year.

In 2010, markets continued to be driven by top down macroeconomic events for a large part of the year with little focus on bottom-up valuation – the so-called ‘risk-on, risk-off’ market where all stocks or credits were highly correlated.

The last four to six months have seen much more emphasis on single name stocks and credits, leading to much more dispersion between various names. Exogenous events such as revolutions, natural disasters or macroeconomic shocks still rock markets as a whole, but in the aftermath we are seeing more differentiation between underlying constituents which is in stark contrast to most of 2010.

As a result of this improved single-name dispersion, fundamental bottom-up hedge fund strategies such as Equity Long/Short and Credit Long/Short have a positive outlook but there are also many other hedge fund strategies that currently have large opportunity sets and for which the future looks rosy.

Strategies for 2011
Event driven strategies, such as Merger Arbitrage, Distressed Investing and Special Situations, are expected to do well due to the increasing numbers of corporate actions on the horizon. We also continue to have a positive outlook for Fixed Income Relative Value and Global Macro strategies given the continued volatility in rates markets and reduced competition in the space; these strategies could also fare very well in a market sell-off, which makes them attractive as portfolio insurance as well as stand-alone investments.

The main sub-strategies where we take less positive a view are those which are more beta-driven such as long-biased equity hedge. The reasons are twofold – we see such approaches as expensive sources of directional market exposure in many cases, but also believe equity market direction still to be far from immune to shock as the impact of spending cuts hit macroeconomic figures and the impact
of low interest rates results in inflation spikes or worse.

Thus, we prefer managers with the ability to take their exposures net short as well as long. This does not mean we will never invest with long-biased equity long/short managers, just that we are incredibly selective when picking funds in this area.

In summary, we have seen an exceptionally volatile start to 2011.

However, the good news is that for those hedge funds with portfolios robust enough to weather these storms, the ensuing opportunities should provide significant future return.

Dr. Chris M. Jones is chief investment officer at Key Asset Management

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