From the November 2007 issue of Investment Advisor • Subscribe!

Hedge Funds Recover Quicker

As headlines buzz with the news that the subprime mortgage-related turmoil did not, in fact, leave the hedge fund industry in smoking ruins, a report from Credit Suisse Index Co. looked back at the aftermath of previous market-shaking events. The verdict: hedge funds as an asset class remained less volatile and better able to produce positive performance through troubled times. Indeed, current results from hedge fund index providers would seem to bear out the theory that hedge funds are able to bounce back quickly. After posting declines in August, returns were up in September.

It's certainly true that funds were buoyed by a soaring equity market--the Dow Jones Industrial Average rose more than 8% from mid-August through the end of September, helping long/short equity managers post the largest gains. But in past market upheavals, hedge funds as an asset class have proven themselves able to resume positive performance faster than global equity or debt markets, and most strategies were able to turn in positive results over the one-year period following a market event.

In their report, the Credit Suisse researchers looked at a rogue's gallery of periods the investment community would probably just as soon forget, beginning with the Asian financial crisis of 1997. They found that after market volatility peaked, hedge fund strategies showed de-correlation with broader markets, and from July 1997 through June 1998 the Credit Suisse/Tremont Hedge Fund Index returned 23.62%. Emerging markets funds were hardest hit, down 17.6% over the 12-month period, but global macro and long/short equity returned 40.53% and 26.21%, respectively, while nearly all other strategies managed gains.

This event was followed almost immediately by a worldwide panic in the late summer of 1998, set off by the devaluation of the Russian ruble and a subsequent moratorium on that country's debt service. This in turn led to the most famous of hedge fund blowups at Long-Term Capital Management. However, in the midst of the turbulence over the year that followed--July 1998 through June 1999--managed futures continued to perform quite well, returning 15.86% for the 12-month period, while long/short equity regained ground quickly and eventually finished with a 17.28% gain. This, according to the research, demonstrated that "while hedge funds as an asset class were hit, the diversification of hedge fund strategies provided some protection." A year later, as tech stocks began to tank in mid-2000, hedge fund performance stayed mostly flat while equity markets plunged. Hedge funds had "quickly adapted to the crisis."

The Lessons of the Past

Hedge fund returns remained mostly steady through the market fears and confusion that followed the terrorist attacks of September 11, 2001, according to the CS/Tremont index. Equity markets, already leaning bearish, fell further, and initially emerging markets and long/short equity went along for the ride, but by the end of June 2002 long/short equity was almost back to where it started, down 0.86% for the previous 12 months, while emerging markets returned 7.45%. Global macro, meanwhile, outperformed all other strategies with a 13.76% gain.

The lessons of the past 10 years, according to the researchers, ought to prove true once again as market participants sift through the credit fallout. "Hedge funds are able to take advantage of new opportunities, such as those created in the past few months, in order to generate absolute returns," the authors wrote.

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