From the October 2008 issue of Wealth Manager Web • Subscribe!

October 1, 2008

STEALTH MARKET VOLATILITY

On the surface, July's market performance seemed to be a welcome respite from numbing losses. Sure, the S&P 500 index posted another down month, but technology stocks and small-cap indices ended in the black. Financial stocks rebounded significantly, posting gains due to better than expected earnings. Commodity prices fell, led by crude oil, which only added to the nearly cheery mood of many investors in an otherwise dark and gloomy summer.

But as is often the case, one man's reprieve is another's worst nightmare.

Plagued by excessive volatility and painful trend reversals, July 2008 may well be remembered as one of the worst months ever for hedge fund returns.

How could hedge funds, whose managers are purported to be the smartest market players around, lose so much money in such a nondescript month?

Although the problems experienced by hedge funds in July were legion, the most significant--and bizarre--was an emergency SEC ruling that dramatically changed short-selling rules for 19 of the largest financial institutions. Coupled with an announcement the following day of Wells Fargo's better than expected earnings, financial stocks rallied dramatically. This caused the overall market, which was down about 5 percent mid-month, to reverse course. The speed and extent of the move proved devastating to a number of long-short equity hedge funds.

Two other trend reversals in equities were also problematic. Going into July, many funds were betting that large company stocks, and those with so-called "high quality" earnings would continue their outperformance. However, both of these predictions failed to occur, which caused losses for equity market neutral funds.

Commodities famously reversed course as well. Both agricultural and energy-related markets retreated significantly. For the legions of global macro funds that had anchor positions in hard assets, the pullback proved quite painful.

The recent market action in currencies also deserves a mention. The U.S. dollar, which has been a bastion of weakness for years, appreciated as financial stocks regained some ground. The greenback also gained on the Euro, which lost ground due to the dovish stance of European Central Bank President Jean Claude Trichet. For the many hedge funds that engage in relative value positions, this move was an unwelcome one.

The Table at left is an indication of the damage. With only a few strategies in the black for the month, most hedge fund-of-funds portfolios likely suffered losses.

It is important to note, however, that hedge funds have outperformed equities significantly in the year to date, as well as in 2007. Further, the types of exposures one captures from owning hedge funds is unique to that asset class, which gives traditional portfolios important diversification.

Hedge funds might have lost the battle, but so far they are still winning the war.

Ben Warwick is chief investment officer of Quantitative Equity Strategies, LLC, in Denver, Colo. and Memphis-based Sovereign Wealth Management, Inc.

Reprints Discuss this story
This is where the comments go.