NEW YORK (CNN/Money) -
Hedge funds headed into the fourth quarter of last year with blah returns to date. But, thanks to a rally in the final three months, they finished 2004 up nearly 10 percent.
A repeat performance might be difficult.
Some economists question whether the traditional fourth-quarter "Santa Claus" market rally is actually going to happen this year. If it doesn't, that means hedge funds, particularly long/short equity funds, which take long and short positions in stocks, may have to be satisfied with the mid-single digit percentage gains they've racked up so far, most of which came during the third quarter.
Larry Smith, the chief investment officer at Third Wave Global Investors, a Greenwich, Conn., hedge fund, is not confident that the fourth-quarter rally that lifted hedge funds will repeat itself, in part because the U.S. equity market will remain sluggish in the near term.
"Hedge funds will continue to make money by picking stocks, but it won't be like the fourth quarter of last year," he said.
"That is not to say people are going to be losing money, but it's hard to see any big rally in hedge funds at this point in time" outside the global macro strategy, in which managers profit from broad trends in global economy, and emerging markets strategies, in which funds invest in the debt and equities of emerging markets, Smith said.
Hedge funds are still outpacing the broader markets this year -- most of the major indexes that track hedge funds have indicated gains of between 5 and 7 percent. And they've done so with less volatility, investors say.
According to Chicago-based hedge fund tracker Hedge Fund Research, its index of 1,600 funds is up 7.3 percent for the year and racked up gains of 5.6 percent in the third quarter. The CSFB/Tremont HedgeIndex, which tracks about 400 funds, is up 5.9 percent for the year. The Standard and Poor's Hedge Fund Index has put fund performance slightly lower, at a 2.42 percent gain.
Tough markets in '05
Some strategies have posted particularly strong numbers. The HFRI emerging markets index is up 14.69 for the year to date, for example.
But when viewed in aggregate, hedge funds are having a tough time in comparison to recent years. Hedge funds produced 15.44 percent gains in 2003; in 2002, when the S&P 500 was down over 23 percent, hedge funds returned 3.04 percent.
Those kind of return justifies the industry's famously high fees to some institutional investors. The typical hedge fund charges a management fee of between 1 and 2 percent and a performance fee of around 20 percent of a fund's gains.
Those fees, which investors are willing to pay for high-performing funds, start to look a lot more expensive when hedge fund performance declines.
Some of the decline in returns has to do with the fact that, as more and more players crowd into the $1 trillion industry, certain strategies that were once profitable have simply become too crowded. There is only so much "alpha," or excess return, that can be squeezed out of the market, which is why industry veterans call the search for alpha a zero-sum game.
But there are also a number of economic factors that have affected hedge fund returns in 2005.
"The key issue has been the rise in short-term rates engineered by the Fed," said Third Wave's Smith. "That's kept U.S. equity prices down. It has kept long-term interest rates from rising because it's kept people confident that the Fed will get ahead of any building (inflation) pressures and it's kept the dollar strong because rising interest rates have attracted a lot of foreign capital. The fundamental question is whether those trends are likely to continue."
Smith said he believes Federal Reserve Chairman Alan Greenspan probably thinks he has more work to do to stamp out any inflation, but it will probably be completed about the time he leaves office early next year.
Better outlook for '06?
Another economic factor that has dogged hedge funds for the last couple of years has been a lack of volatility, or swings in the markets. Hedge funds tend to outperform the broader equity markets during periods of volatility.
Peter Borish, who manages a global macro hedge fund called Twinfields Capital, said that while volatility may not have hit its lowest levels yet and we may see another decline before it perks up again, he thinks volatility will come back soon. That's good news for hedge funds.
"We are in an unprecedented period of macroeconomic stability," he said. "Look at quarter-to-quarter changes in GDP. It hasn't been this stable, ever. The result of stability is low volatility."
Borish said hedge funds do well when the economy moves from one macroeconomic equilibrium to another -- in other words, when the markets reach an "inflection point," or a turning point after which conditions change.
"We have been through this period of historical low volatility," he said. "But if you look under the surface and you see that the seeds are really being planted for macroeconomic change. It doesn't really matter whether that change is an improvement. You'll get a lot of valid intellectual arguments in either direction, up or down. All we need per se is movement out of that."
While that could mean good news in the near term, Borish, like Smith, is not bullish on the prospects of a fourth-quarter rally in the U.S. equtiy market.
"I'm skeptical," he said. "There is no negative sentiment, and there is a level of complacency that has me concerned."
Why '05 has been tough for hedge funds: more here.
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