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Turbulent times upend hedge funds

Hedge funds hoping for a brighter start to the year after a largely underwhelming 2021 have instead been handed a whole new set of market problems to deal with.

A frantic couple of months, including a vicious sell-off in technology stocks, followed by the market fallout from Russia’s invasion of Ukraine, have left many managers nursing double-digit losses. Funds were on average down 2 per cent this year to Wednesday, according to data group HFR.

“There’s an enormous amount happening,” said Kevin Russell, chief investment officer at UBS O’Connor, which manages $11.2bn in hedge fund assets. “There’s been significant change in the policy landscape, geopolitical instability. It’s been a tough environment for risk.”

The year’s upheaval began as investors readjusted to the prospect of a faster-than-anticipated interest rate hiking cycle. Many high-flying tech stocks favoured by some hedge funds were hard hit as the likelihood of higher rates made their future cash flows less attractive. Funds racing to slash their exposure to tumbling tech stocks often found themselves caught in a rush for the exit.

Among those to suffer losses were “tiger cubs” Lee Ainslie’s Maverick Capital, which is down around 12 per cent to late February, and Steve Mandel’s Lone Pine, which took double-digit losses in January.

“Sharply falling growth stock valuations, declining hedge fund leverage, retail selling, worsening equity market liquidity, and the underperformance of popular hedge fund long positions have created a vicious cycle in recent months,” wrote Goldman Sachs in a recent note.

The market fallout from the Ukraine war then wrongfooted funds that had been frantically moving out of these growth sectors and into cheaper, so-called value or cyclical stocks. But rather than providing a safe haven, some stocks like banks, for instance, tumbled as investors worried over banks’ exposure to Russia and questioned whether the conflict would slow the pace of rate rises.

Hedge funds “were not positioned well, at the sector level”, for the outbreak of war, wrote Morgan Stanley in a client note, pointing out that funds had been holding large positions in sectors such as banks, travel and luxury.

Even though many managers had thought a full invasion unlikely, the direct fallout from the war on hedge funds has so far been limited, however. The Financial Times revealed this week that a number of funds had been caught with positions in Russia or Ukraine going into the conflict, including emerging markets firm Pharo Management, one of the sector’s most consistent performers. But, while painful, the losses are far from catastrophic.

Nevertheless, it marks another blip for a $4tn sector that has often found markets hard-going over the past decade.

After a bumper 2020 when hedge funds came through the onset of the coronavirus pandemic largely unscathed, last year was meant to be the year when the industry kicked on and took advantage of stocks mispriced by the previous year’s volatility and a return to more normal market conditions. Their supposed ability to pick the best stocks to buy or bet against would now come to the fore.

Instead, they were faced with a strong and lengthy market rally, driven by a small number of mega-cap stocks in which many funds held relatively light positions. While the S&P 500 rose nearly 27 per cent, to the delight of investors holding low-cost tracker funds, hedge funds returned a more modest 10.2 per cent, according to HFR. So-called “alpha” — industry jargon for the value that hedge funds add above and beyond overall market moves — was distinctly lacking in many parts of the industry.

“Are investors happy with an 8 per cent return if the market is up in the 20s per cent? It depends how much is alpha,” said Marlin Naidoo, global head of capital introduction at BNP Paribas.

The hedge fund industry is a curate’s egg at the moment. While some equity and macro managers have found life hard-going, multi-strategy funds such as Citadel and Millennium have been thriving, making them highly popular with investors.

BNP found in a survey of investors with $1.2tn in assets that multi-strategy funds were set to enjoy the second-highest level of inflows of any strategy, behind only funds betting on specialist equity sectors such as healthcare, this year. But Naidoo added that, given hedge funds’ strong performance in 2020, “one may have expected net inflows [into the industry as a whole] to be a bit higher” last year.

Hedge funds’ big selling point should be that, with equity and bond markets in the red this year and geopolitical worries aplenty, they can protect investors’ money and then profit from falling asset prices. Some managers are already taking full advantage. But, for much of the rest of the industry, there is still work to do.

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