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Funds of hedge funds could face mauling if bear emerges

S&P Fund Services says the biggest risk to funds of hedge funds is if the recent volatility turns into a bear market.

The company says the funds it rates have generally performed well this year despite concerns over black-box quant models breaking down in the recent market turbulence.

S&P concedes that the black-box quant models used by statistical arbitrage, some macro hedge fund managers and commodity trading advisors can be high risk but, for the fund of hedge fund managers rated by S&P, these strategies represent a small part of the overall portfolio.

Typically, exposure to statistical arbitrage is around 3 per cent while CTA and macro represents about 8 per cent and 12 per cent respectively.

S&P says most of the funds of hedge funds in its universe mainly hold long/short equity funds and the biggest risk to them is if the market correction becomes an extended bear market.

Fund analyst Randall Goldsmith says: “One thing I have noticed is that over the past three to four years, correlation with funds of hedge funds has been moving up with equities. Funds of hedge funds are equipped to cope much better in a bear market than the majority of funds but they will suffer, although not to the degree of long-only funds.

“Funds of hedge funds were helped in the last market by long/short equity funds that invested long in small to mid caps and short in blue chips. This is not available to them now because small and mid caps are no longer cheap.”

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