Stressful times for world economy as hedge funds ponder options

Perchance he for whom this bell tolls may be so ill, as that he knows not it tolls for him…

No man is an island, entire of itself; every man is a piece of the continent, a part of the main. If a clod be washed away by the sea, Europe is the less, as well as if a promontory were, as well as if a manor of thy friend’s or of thine own were: any man’s death diminishes me, because I am involved in mankind, and therefore never send to know for whom the bells tolls; it tolls for thee.

Meditation XVII by John Donne, English metaphysical poet, satirist, lawyer and priest ­(1572‑1631)

Continued unrest in the Middle East and North Africa, fighting in Ivory Coast’s main city Abidjan, the never-ending agony of eurozone countries Greece, Portugal and Ireland coupled with the indecision and not quite helpful assistance from the other members, Japan’s prolonged agony with the Fukushima nuclear plant’s increasingly high radiation leaks as well as the task of coping with the emotional and physical aftermath of the earthquake and tsunami, growing worries over inflation, fears of a banking crisis in Asia, rising commodity costs, increased oil prices. Cue another major ­incident.

The world appears even more unpredictable, fragile and volatile than usual. It is as if the financial crisis was the warm-up act for a string of continuing major events that pound the world economy and man’s ability to take it all in. People used to worry about donor fatigue. What about crisis fatigue?

How long, for example, will the drama with Europe’s banks, the continuing saga of the eurozone’s inability to react in a coherent fashion to a crisis and the general dramas of European Union politics go on before everyone simply turns aside, not bored with the bombardment, but unable to cope with any more?

Tragedy surrounds us – from the heart-rending films and photos of a devastated Japan mingled with terror and death in the Middle East and North Africa interspersed with mayhem and bloodshed in Côte d’Ivoire. The world seems in constant flux and disarray and that is before turning to the continued impact the financial crisis is meting out to the average man on the street regardless of location. Perhaps now is the time to de-camp to the palm-strewn island or go pick berries in the woods.

With the first quarter behind us, the question now is what the second quarter of the year will bring. Investment opportunities, despite the upheaval, abound and hedge funds are well placed to start to take advantage of these. As allocation to alternatives (and hedge funds) increase from institutional investors, portfolio managers will be under even more pressure to produce pure alpha and not just market beta.

This is a time where hedge fund managers can redeem themselves and regain the confidence of investors (as well as attract new allocators) by proving their worth. Smart managers should be able to produce the returns hedge funds are supposed to be famous for.

On the other hand managers are perhaps much more at the mercy of political risk factors than previously. How they interpret and respond could mean the difference between positive or negative performance by year end.

More factors need to be put into the equation. With human behaviour the most unpredictable and disruptive element for markets, managers may need to start putting more resources into less traditional areas of research in future. At the same time there appear to be some strategies that will benefit most from the present climate. Distressed debt is certainly back on the agenda and there are clear signs managers are moving into this area.

Commodity traders will be looking at a variety of possible trades, particularly in wheat and oil. One new element that could make things more interesting is the use of Twitter for ‘real time’ information on such things as crop conditions and harvests. How managers embrace this new source of information will be interesting to watch.

Meanwhile, the next quarter will bring with it some major changes in the lives of some US-based hedge fund managers as the deadline for Securities and Exchange Commission registration looms. While most of the information to be made public will not give much concern to hedge fund managers, some of the reporting directly to the SEC on systemic risk factors may cause an eyebrow or two to lift.

The SEC’s push for more transparency is going to put pressure on the UK’s Financial Services Authority to follow suit.

Clearly more, not less, information about the activities of hedge funds will be requested by regulators. This is a good thing and something the industry needs to embrace rather than moan about. Now that institutional money forms the majority of hedge fund assets under management, there will be strong arguments that greater release of information about strategies and the operational risk controls of funds should be made.

The ultimate investors into hedge funds are rapidly becoming individuals who trust their pension providers to make the right choices on investments. This could be one of the stronger reasons for hedge funds to become less ‘secretive’ about operations and start explaining what they do and how they do it. Regulation is clearly going to push this trend.