Hedge fund investors scarred by global credit crisis losses are setting their expectations lower and beginning to content themselves with smaller gains they would have balked at two years ago.
As if to make the point, hedge funds posted small gains in July but lagged the broader market because many managers played it safe after market tumult in May and June took a bite out of their portfolios, according to data released Friday.
The average hedge fund gained 1.9 percent in July after losing 1.35 percent in June and falling 3.01 percent in May, consultants at Hennessee Group found.
The broader Standard & Poor's 500 index climbed 6.88 percent last month. July's performance left hedge funds with a gain for the year of just 1.87 percent, while the broader market was down 1.21 percent.
The smaller returns appear to be a growing trend. Widespread expectations before the credit crisis, fostered both by over-optimistic hedge funds and wide-eyed investors, that funds could make money in all markets were confounded by 19 percent losses in 2008 and followed up by smaller losses in the first half of this year.
Before the crisis set in, investors' expectations were also fuelled by the high fees that hedge funds charge — often 2 percent a year on assets and 20 percent of performance — which have, contrary to many commentators' expectations, largely survived the credit crisis.
Investors — and the funds themselves — are now less optimistic both for the size of returns and for how regularly these profits can be made, after the crisis showed many funds were highly correlated both to their peers and to financial markets and therefore vulnerable when conditions change.
"People have toned down their expectations. Nowadays, 10 percent a year looks pretty good," said Odi Lahav, vice president at Moody's alternative investment group. "In '06 or '07, 10 percent would not have gotten investors' attention, when you had some spectacular returns of over 1,000 percent in one year, usually involving some large energy bets."
Trafalgar Capital Advisors, which is raising money for a new Cayman fund that offers loans to small, quoted businesses, said its target returns of 12-14 percent a year now looked more attractive to potential clients.
"Three to four years ago people were saying 'that's ok but we want something spicier than that', but now views are changing," said managing partner Andrew Garai.
Nevertheless, some investors still believe the hefty fees they continue to pay should give them higher gains all of the time.
"Some investors still have very strange expectations," said Fabrizio Ladi Bucciolini, head of alternative investment at Swiss-based Reyl Asset Management. "They think, 'we're in a hedge fund, we should get a minimum 25 percent a year'."
Such expectations were fostered by the benign, rising markets before the credit crisis, which helped the average fund return close to 10 percent or even better for five straight years between 2003 and 2007, according to Hedge Fund Research, and persuade some funds to believe their own hype.
"You did see funds in their marketing material saying 'we believe in any market we can make 10 percent a year'," said Mark Wightman, Head of Strategy, APAC, at software group SunGard. "People are seeing things more realistically now."
However, the crisis which followed the collapse of Lehman Brothers played havoc with hedge funds' performance records.
The average fund lost 15 percent in the September, October and November of 2008, as many funds said the abnormal events made running their strategies almost impossible.
Some high-flying funds were also brought back down to earth with big losses. Martin Hughes' Toscafund saw its flagship fund lose around 60 percent in 2008 while Polygon Investment Partners' main fund lost 48 percent.
"I think it is likely that the 2008 experience forced many hedge fund investors to challenge both their return and correlation assumptions," said Fredrik Martinsson, CEO of ATP's Alpha unit, which runs 5 billion Danish crowns ($881 million) in hedge funds.
Given that hedge funds tend to underperform in bull markets and outperform in bear phases, due to their hedges, a more realistic expectation might be for them to beat lower cost mutual funds and make money over the long term, according to Moody's Lahav.
"In an equivalent strategy you could expect a hedge fund to produce positive returns and outperform a mutual fund over the long term, but your measurement date is extremely important.
"There's no strategy that always makes money and that can remain unscathed in any crisis," he added. "Investors who saw hedge funds as a cure for everything were perhaps a bit deluded."
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