From the February 2009 issue of Wealth Manager Web • Subscribe!

Down, But Not Out

With disappointing performance greeting them in the first two quarters of the year, liquidity restrictions taking hold in the summer, and the largest corporate scandal in history hitting them in December, hedge fund-of-funds investors have been on their heels all year long.

That's the bad news. The good news is that, as in previous years, hedge funds in aggregate outperformed stocks by a wide margin in 2008. And the same is likely to occur in 2009--a year that should see asset classes of all types register gains.

For a perilous example of just how bad things are for alternatives, just look at convertible arbitrage managers. Their strategy involves buying a firm's convertible bonds and hedging exposure by short-selling its company's stock. Historically, the ability to lock in a very efficient hedge while capturing the convertible bond's interest payments meant that convertible arb managers were able to generate roughly 1% per month with minimal volatility.

The credit crisis changed all that. As banks struggled with mortgage-related losses and hedge fund investors rushing for the exits, global liquidity in the credit markets all but dried up. Prices for convertible bonds cratered along with everything else.

And thanks to new restrictions on short-selling by the Federal Reserve, holders of convertibles were unable to hedge their equity exposure. The resulting perfect storm created a loss of nearly 40% for convertible arbitrage hedge funds last September and October.

All is not lost, however.

The ashes from the implosion of the credit markets will eventually become the fertile soil of the hedge fund industry's rebirth. A plethora of managers sitting on dry powder are ready to scoop up the significant discounts available in corporate loans, bonds and other broken pieces of the fixed-income market. Stocks aren't exactly expensive, either; any sort of non-worst-case scenario in the economy is likely to spark a decent sized rally that will 'reflate' the price of all assets.

With the potential for such a nice bull move, why are hedge funds poised to outgun the equity market yet again next year?

The reason is simple: Corporate debt is much cheaper than stocks, and any recovery in that asset class is likely to be more significant. Similarly, in 2003--at the beginning of the bull run in stocks that began in the aftermath of the WorldCom debacle--high-yields and convertibles smoked stocks. Corporate loans and high-quality corporate bonds are poised to do the same thing next year.

If better times don't emerge for stocks, my prediction will likely still come true. Since corporate debt sits higher in the capital structure, bondholders fare better during bankruptcies.

In either case, those willing to stick with hedge funds should do fine in '09.

Ben Warwick is Chief Investment Officer of Quantitative Equity Strategies, LLC, in Denver, Colo. and Memphis-based Sovereign Wealth Management, Inc.

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