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Investment of the quarter: Hedge Funds…with a few caveats

Given all the fuss in the media about problems in southern Europe, you would have thought the entire region was about to go pop.

Given all the fuss in the media about problems in southern Europe, you would have thought the entire region was about to go pop.

Maybe it will. But global markets have been phlegmatic, as shares have risen to multi-year highs. Wholesale market liquidity has improved, leading to a fall in volatility. The correlation between stocks has fallen by about a fifth, as they move in line with corporate fundamentals, rather than the ebb and flow of macro fear. Takeovers and stock market floats are growing in number and size.

For all this, and hopefully more to come, we should thank the world’s central bankers, who have agreed to print as much money as it takes to facilitate economic growth. This comes with political strings attached in Europe, as recent events in Cyprus have illustrated. But, for now, the only way is up.

In February, Federal Reserve chairman Ben Bernanke gave the bull markets a public boost by saying to the Senate Banking Committee in Washington: “We do not see the potential costs of the increased risk-taking in some financial markets as outweighing the benefits of promoting a stronger economic recovery.”

If the current measures succeed, the global economy – led by the US and emerging markets – will surge forward. If growth falters, money printing will continue, which will also provide support to equities. And if the printing leads to inflation, equities can hedge against that as well.

But investors need to be smart to navigate their way through a rising but nervous market. It is time to increase allocations to hedge funds, whose remuneration structure richly rewards talented individuals. 

The funds best placed to deal with current equity market conditions are those that take long positions in stocks with good prospects, but short in those likely to hit problems.

These long/short hedge funds had a terrible time when good and bad stocks were moving up and down in unison. But they roared back into fashion in the last quarter of 2012, when corporate fundamentals reasserted themselves. Stock market momentum has become their friend, together with shorting opportunities, which will multiply in number as share ratings become increasingly demanding. 

A recent survey by Credit Suisse found that long/short had become the most popular hedge fund style among institutions, with support from 35% of respondents. Bob Leonard, the bank’s global head of capital services, recently said: “Equity long/short is back on top. There’s been a huge rebound.”

Seasoned long/short hedge fund managers generated double-digit returns last year, mainly thanks to a sublime fourth quarter, beating the 13% generated by the MSCI World index. The average of the Dow Jones Credit Suisse Long/Short Equity index was less impressive, at 8.2%. But long/short looks set for renewed growth in 2013 –correlations between good and bad stocks are currently down to levels not seen since 2007.

You need to carry out your own research when deciding how to invest in hedge funds. But success often breeds success when the direction of markets becomes settled. 

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