Hedge Funds

Hedge funds responded in line with other risk assets during 2009 as policy induced asset price re-inflation drove many investors out of low risk assets. While some of the bounce back in prices was a result of depression risk being re-priced out of these assets, a significant component of the revaluation was a result of portfolio shifts from investors being driven from low yielding treasury securities by very accommodative monetary policy. Hedge funds participated actively during this period with many reclaiming their high water marks established in 2008.

The underlying economic environment, while improving, is still fraught with risks. Growth, at best, will likely be well below trend for a significant period of time even as it occurs on a low level of economic activity. Additional shocks to the system could create significantly worse outcomes. Fiscal policy has slowed financial deleveraging by "pulling forward demand" and exchanging household debt for government debt. In the U.S., monetary policy has de facto guaranteed a large portion of financial assets and bank liabilities in the economy. Consequently, financial market performance remains highly dependant on government support. Policy mistakes (or perceptions thereof) can still lead to substantial volatility in markets.

For hedge funds this translates into potential opportunity. Asset price volatility will likely continue to be elevated for some time as natural corrections to market run ups and policy shifts will affect market liquidity. As this occurs, the liquidity-driven, low asset price dispersion environment of 2009 will give way to more fundamental value opportunities allowing security selection to drive performance on both the long and short sides of portfolios.

We believe that potential opportunities in the near term continue to lay in credit-oriented strategies, especially those focused neutral to short high yield and long distressed credits. Relative value strategies, which arbitrage market participant disagreements over asset prices, offer potentially attractive return opportunities that generally have low correlation to traditional asset markets. Most macro-oriented and commodity-oriented strategies offer higher risk but also potential opportunities for attractive rewards should the economy falter. As the year progresses, security selection strategies in hedged equity and long/short credit should provide improving opportunities as valuations rationalize between issuers in these markets.

It is our opinion that the key to success in hedge fund investing today is to diversify across a broad set of hedge fund strategies and maintain a balanced long-short approach. Focus for 2010 should be toward those that do not require directional views of either the equity or credit markets but rather offer low correlation. Directional strategies should be offset with short strategies in order to isolate uncorrelated sources of return. This balance will help to mitigate negative performance should the economy falter yet provide return through security selection in most other situations.