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Hot tips: trends for 2008

Despite some high profile failures hedge funds had a successful year in 2007. As investors evaluate which funds will perform best in 2008, Reg Crowder meets the experts to shed some light on the trends to watch over the next 12 months

Eliza Lau, CEO of the Hong Kong-based "funds of hedge funds" manager SAIL Advisors, doesn't need any opinion surveys to see where hedge funds are headed in 2008. Her incoming and outgoing calls tell the story.

A surprising number of calls are coming in from European, Middle Eastern and US investors who want to put money into Asia's growing economies, she said. The reason for those outgoing calls is that it takes Lau a lot longer than it once did to catch up with a fund manager specialising in distressed assets. The manager had so many too-good-to-pass-up deals on his plate that he could hardly find time to deal with
anything else.

Asian strategies
At the beginning of the year, fund researcher Lipper surveyed global hedge fund managers to find out what they thought was in store for hedge funds in 2008. The managers predicted that emerging markets – mostly Asian – and distressed assets would be two of the best-performing strategies in the upcoming year. Aureliano Gentilini, Lipper's global head of hedge fund research, and Ferenc A Sanderson, a senior research analyst with the firm, painstakingly went through the data line-by-line to identify important new trends.
 
What they found was that in addition to the enthusiasm for emerging markets and distressed assets, global macro and long/short equity were especially popular with the fund managers.

Hedge Fund Research. meanwhile, reported that Asian emerging market strategies produced 33.4% returns in the 12-month period ending in December. Not surprisingly, it didn't take long for the word to get around.

"We are getting a lot of calls from new investors we have never heard from before who are interested in investing in these strong Asian economies," Lau said. "We have a lot of very good, high quality, growing companies in Asia. Because of these strong economies, we also have some very strong national currencies, which opens up some additional opportunities for currency trading," she continued.

However, there is the other side of the coin. Fund managers can't just accept investments. They have to put the money to work in the real world.

As a manager who puts together funds of hedge funds, SAIL Advisors has to be on the lookout for hedge fund managers who can deliver the above-market returns that prospective hedge fund investors demand.

Lau said the busy distressed asset manager mentioned previously used to hold about 30% of his assets in cash. But in the face of the tremendous flow of sensational distressed deals coming his way, he's cut his cash allocation back to 10%, she said.

A hot new strategy
Asia's explosive growth is nothing new. But the sudden arrival of distressed assets as a hot new strategy might come as a surprise to some. A statistical oddity has for several years hidden from view the rising yields hedge funds have been extracting from distressed asset strategies. The UK-based private research company Oxford Metrica only recently spotted this fact.

As it turns out, widely-followed hedge fund indexes routinely lump distressed-based strategies in with other event-driven strategies, assuming that they are related strategies that behave similarly. But they don't.

And this is not some new phenomenon that has burst upon the scene following the collapse of two Bear Stearns hedge funds, marking the onset of the global liquidity crunch.

Working with the popular FTSE Hedge Index, Oxford Metrica discovered that distressed asset funds had been improving their performance – compared with other hedge fund strategies – for six years. For many investors, this was a surprise.

In the case of the FTSE Hedge data, much of the reporting combines the stronger "distressed and opportunities" strategy with the weaker "merger arbitrage" strategy into a single "event driven" category.

Buried under this layer of averages and categories, the distressed and opportunities strategy generated a stunning five-year performance figure of 58% – beating the overall FTSE Hedge Index and every other strategy tracked by FTSE Hedge. For someone pursuing a five-year investment strategy, overlooking a trend that powerful could be very expensive, indeed.

But perhaps Oxford Metrica's most critical discovery was that the greatest single threat to a hedge fund's performance was "style drift", in which the fund manager shifts from one strategy to another in a desperate scramble for high yields.

The study produced "statistical tools" to promptly identify such drifting funds and help investors avoid them – or get out of them as fast as possible. While the statistical tools were still being refined, they identified the likely collapse of Amaranth Advisors, which is the current world record holder for the biggest hedge fund collapse in history – it lost roughly $6 billion in one week.

The Bank of New York Mellon commissioned the Oxford Metrica study as a part of the asset manager's effort to find better ways of evaluating hedge funds.

Identifying false performance
The Oxford Metrica work is only one example of recent research into hedge fund behavior likely to bring a wealth of benefits – including peace of mind – to hedge fund
investors.

Two academic researchers in the US recently published techniques for identifying false performance data reporting by hedge funds. Nicolas Bollen, an associate professor of finance at Vanderbilt University, and Veronika Krepely Pool, an assistant professor of finance at Indiana University, found that 10% of the hedge funds in the database they studied distorted their returns to investors by hiding losses.

The good news is that the statistical "screens" developed by Bollen and Pool are no more difficult or complex than those routinely run by institutional investors every day in the normal course of business.

"The investors could run these screens and use them to identify funds that that may have altered their numbers," Pool said. "These changes leave statistical footprints. They leave behind evidence that the numbers have been changed."

GIPS
Yet another plus in 2008 for prospective hedge fund investors is the growing acceptance of Global Investment Performance Standards (GIPS) by hedge fund managers. GIPS is a global, standardised approach to presenting investment results to prospective clients. Investment managers outside the hedge fund community have used it for years.

"I tell my clients that GIPS is nothing more than getting your house in order and making sure you're following best practice," said Anthony Howland, chairman of the London-based company Performa, which creates software to help investment managers comply with GIPS.

Many investment managers and funds with institutional clients are either already GIPS compliant or moving toward bringing themselves into compliance, Howland said.

He said the larger institutions increasingly demand GIPS compliance before they will even consider doing business with a hedge fund manager.

Howland said private investors benefit because most managers of hedge funds and funds of hedge funds who deal with private investors also do business with institutions. "Private investors would be wise to ask whether their fund manager is GIPS complaint," he said.

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