Hedge funds will improve returns next year, says Hennessee Group, an adviser to hedge fund investors, in its annual review of the year and forecast for the next twelve months.
In 2004 hedge funds generally trailed the broad market averages, as the S&P 500 DRI advanced +10.9%, while the Hennessee Hedge Fund Index advanced +8.3%.
The underperformance, says Hennessee, was primarily due to conservative net exposures due to uncertainty related to Iraq and the election, as well as the impact of high oil prices on consumer spending; low volatility in the equity market; low interest rates; the difficulty for hedge funds when the equity market is in a narrow trading range (i.e. 1994 and 2004); and the high correlation and low dispersion of returns among stocks.
The Hennessee Long/Short Equity Index advanced +8.4% in 2004. While 2004 was more favourable for short selling in comparison to 2003, most managers were unable to generate significant profits on the short side due to the strong fourth quarter for the equity market. Furthermore, value continued to outperform growth strategies, as energy, utilities, and industrials were the top performing sectors.
The Hennessee Arbitrage/Event Driven Index advanced +8.0% in 2004. Returns in arbitrage and event driven strategies continued to be driven by distressed and credit related strategies, as convertible arbitrage (+1.2% in 2004) and merger arbitrage (+4.5% in 2004) generated lower returns. The Hennessee Distressed Index advanced +18.5% for the year, as credit strategies continued to benefit from tightening in high yield credit spreads. Convertible arbitrage suffered from low interest rates, declining levels of implied volatility, and lower levels of convertible bond issuance. While spreads improved in merger arbitrage due to higher interest rates and merger activity, performance suffered from a number of deal breaks in the second and third quarter.
Most market participants expect relative performance for long/short equity strategies to improve in 2005, says Hennessee. For long/short equity strategies, higher interest rates and lower levels of liquidity are likely to be met with lower GDP growth and slower corporate earnings growth. This environment typically creates a more favorable environment for stock picking and short selling, as high quality companies generally outperform low quality companies.
Most long/short equity managers expect equity market returns of 8-10% in 2005, says Hennessee, recognizing that earnings growth will be necessary to drive stock prices higher. Most believe that a rising interest rate environment is rarely met with higher price-to-earnings ratios. Consensus estimates indicate expectations for corporate earnings growth of 10% in 2005.
Most managers expect improved returns in convertible arbitrage and merger arbitrage in 2005, says Hennesses, although they are expecting lower returns in distressed and credit related strategies in comparison to 2004.
Expectations are for 5-6% returns in convertible arbitrage in 2005, assuming no increase in leverage in comparison to 2004. However, returns could be higher as a result of higher implied volatility and higher levels of convertible bond issuance. The VIX is currently at levels not seen since 1995.
Despite continued investor interest in distressed and credit strategies, most multiple strategy arbitrage funds continue to reduce exposure. The Merrill Lynch High Yield Master Index is currently yielding 7%, the lowest yield since 1997.
Most managers expect returns for merger arbitrage to be approximately 8% in 2005 as a result of higher interest rates and higher levels of merger and acquisition activity in the U.S., Europe and Asia.