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Singles champions

Although single-strategy hedge funds vary tremendously in their characteristics, there are some common threads between them, most evidently in their approach to risk and return.

Unlike traditional long-only managers, most hedge fund managers have an absolute return approach to investment.

They define risk in terms of the potential loss of invested capital rather than the deviation from a stated benchmark.

When it comes to generating investment return, hedge fund managers also generally look to achieve an investment return which is unrelated to the direction of the market. There is a focus on the generation of alpha rather than the combination of alpha and participation in the market, known as beta, offered by long-only managers. This is why it is often said that hedge fund returns are based largely on manager skill rather than the performance of the underlying asset.

Beyond those common features though, it is a broad universe. There is no standard classification system adopted by the industry, and it is possible to group them in a variety of ways – by investment process or strategy, by geographical location, by industry sector or by return driver.

The approach we have taken is to analyse them on the basis of investment process or strategy and by asset class. We have then sought to group them into one of three broad sets – directional, semi-directional or non-directional.

Directional strategies tend to generate returns based on an assessment of current market conditions and investment opportunities. They have the potential to generate high levels of absolute return by participating in the directionality of the market, whether moving higher or lower, but will tend to have a lower-risk adjusted return than other strategies because there is an inherent level of risk in making large directional “calls” on the market.

Global macro funds come within this category, with managers such as George Soros famously taking a top-down thematic approach to market opportunities, opportunistically allocating capital across a wide variety of strategies and asset classes. Managed futures and distressed strategies also come within the “directional” umbrella.

Managed futures strategies, known as commodity trading advisers, invest on the perceived direction of currencies, commodities, equities and fixed-income securities, sometimes following price trends and sometimes using fundamental analysis.

Semi-directional strategies tend to rely on the identification of mispriced securities, with market directionality also contributing to investment returns, although less so than with fully directional strategies.

We classify merger arbitrage and event-driven strategies within this heading, along with long/short equity – or hedged equity – managers.

Merger arbitrage managers try to capture the difference between the current market value of a security and its worth if a deal is successfully concluded. A crucial part of this is an assessment of the likelihood of the deal closing and the timeframe.

Typically, the manager will buy the stock of the target company and sell the stock of the acquiring company. An assessment of the economic environment is also important in this strategy.

Long/short equity strategies encompass many managers. This has become the most popular area of alternative investing. Here, managers will buy stocks which they believe will do well and sell stocks which are likely to do badly. Depending on the strategy of the managers, the portfolio may have a net long or a net short bias, and so participate in the directionality of the market.

A fully hedged long/short equity strategy would have no directionality, with returns coming from the price movements of individual stocks. However, there may still be sector, capitalisation or other tilts within the portfolio.

Taken to its extreme, such a fund would move into our third grouping of hedge fund strategies, those which are non-directional.

These strategies are the embodiment of the idea that a hedge fund should focus on the generation of alpha, without exposure to the direction of the market.

They will typically offer the most attractive return on a risk-adjusted basis, although the absolute level of return may be lower than for other strategies.

Into this grouping come equity market neutral strategies, which profit from differences in companyspecific performance by buying shares in one company and selling another of similar size in a similar industry. So far as possible, the manager does not take market or sector risk.

Also in this category are convertible bond arbitrage and fixed-income arbitrage, which seek to profit from price anomalies. Convertible bond managers typically buy the bond and sell the shares of the company, taking advantage of any volatility in the share price and any changes in the credit rating of the bond.

Similarly, fixed-income arbitrage takes advantage of price differences between similar instruments, with the goal of generating steady returns with low volatility. A feature of this strategy is a high level of leverage in the fund, to magnify the effect of small price changes.

Global macro strategies turned in some of the strongest performances last year, with successful managers proving able to anticipate more robust growth in the US and the changing interest rate environment there.

So far this year, though, the strategy has been less successful. Rapid swings in market sentiment have made it difficult for macro managers to implement their strong directional views and the result has been a lower level of conviction in the portfolios.

Having reduced exposure to the strategy towards the tail end of last year, we may begin to add to it again as the summer progresses.

Managers specialising in distressed investment opportunities had an even more fruitful year. It was the best-performing strategy in 2003, with managers able to make strong gains from companies which managed to turn around in a more buoyant economic environment.

Ironically, this is a difficult area to invest in as many hedge funds look to lock capital up for 12 months from initial allocation. Several managers in this strategy have started to broaden their skill base to encompass a long/short investment strategy in credit bonds. This is a new investment strategy but it has been a successful one and our exposure here has generated positive returns.

We believe the prospects for event-driven managers are bright and we have recently increased our exposure. This has been another top-performing strategy as equity market sentiment has picked up. Although press coverage would suggest that merger arbitrage managers have also been operating in a favourable environment, this strategy has not done quite so well.

The volume of merger and acquisition deals has been fairly modest below a handful of well publicised names, and the probability of them not reaching closure has been high.

However, here too, the prospects are improving, and we are becoming more upbeat on the strategy, particularly in Japan.

Returns from long/short equity strategies have ten-ded to be somewhat lacklustre over the year to date. In an environment in which investors have become concerned about the prospect of higher short-term interest rates, many managers have been caught with too much directional exposure in their portfolio.

The exception has been Asia, where inefficient markets have provided excellent opportunities for nimble managers. Having reduced exposure in the first half of last year, we have gradually been adding to it again, favouring managers in Asia and in Japan where the prospects are very encouraging.

Fixed-income arbitrage strategies performed well last year, with the portfolio diversification and excellent risk-adjusted returns offered by the strategy finding favour with investors in what was a difficult environment for many other managers.

However, as with long/ short equity strategies, if short-term interest rates are set to move higher around the world as we are expecting, bonds are likely to weaken as an asset class and we are likely to see a number of credit issues beginning to emerge.

We will be monitoring the situation closely over the coming months, possibly with a view to reducing our current exposure to the strategy to a more cautious position.

Unlike fixed-income arbitrage strategies, convertible arbitrage strategies had a disappointing 2003 and this weak performance has continued into 2004.

The level of convertible bond issuance was low and bond markets, especially credit markets, have been expensive.

We do not believe that the environment is likely to become significantly more easier as the year progresses but we do expect to retain a moderate exposure to the strategy as managers have shown themselves adept at taking advantage of any change in economic circumstances rapidly.

In summary, then, our world view that we are entering a period of synchronised economic growth has informed our strategy selection for the funds of hedge funds we manage.

We are most favourable on long/short equity managers, particularly those operating in Asia and Japan where the prospects look most attractive. At the same time, we believe that fixed-income strategies are likely to face a headwind from the prospect of rising bond yields and we expect to remain fairly cautious on this area of the market in the medium term.

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