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Portfolio > Alternative Investments > Hedge Funds

Hedge Funds and Market Meltdowns

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Index November 2003 QTD YTD Description
S&P 500 Index* 0.71% 6.25% 20.27% Large-cap stocks
DJIA* -0.19% 5.47% 17.27% Large-cap stocks
Nasdaq Comp.* 1.45% 9.70% 46.78% Large-cap tech stocks
Russell 1000 Growth 1.05% 6.73% 25.41% Large-cap growth stocks
Russell 1000 Value 1.36% 7.56% 22.48% Large-cap value stocks
Russell 2000 Growth 3.26% 12.18% 47.88% Small-cap growth stocks
Russell 2000 Value 3.84% 12.30% 40.93% Small-cap value stocks
MSCI EAFE 2.24% 8.62% 29.08% Europe, Australasia & Far East Index
Lehman Aggregate 0.24% -0.69% 3.06% U.S. Government Bonds
Lehman High Yield 1.52% 3.57% 26.12% High-yield corporate bonds
Carr CTA Index -0.19% 1.69% 12.35% Managed futures
3-month Treasury Bill . . 0.93%
Through November 30, 2003. *Return numbers do not include dividends.

With the stock market holding onto its impressive gains, a number of pundits are calling this recent run a sucker’s rally. From a valuation standpoint, it’s easy to see why. Internet-related issues such as Yahoo! and eBay, among others, are trading at a trailing P/E of over 100. If the potential growth of such names does not justify their valuations, it seems logical that stocks may be in for a corrective phase. The fixed-income sector has its fair share of detractors as well. Short-term interest rates cannot be artificially held low forever; when the Fed finally decides to hike, bonds could be summarily slammed.

Government paper isn’t the only thing that thoughtful investors are worrying about. Accounting troubles at Freddie Mac have created some concern for the mortgage-backed security market. And one shouldn’t forget the trouble convertible bonds ran into this past summer.

What do these doomsday scenarios hold for hedge fund investors? Probably not a lot. According to a number of recent studies, hedge fund factor exposures (the measure of what drives returns) are far from stable–a fancy way of saying that hedge fund portfolios are likely to change with market conditions.

Those who were invested in hedge funds in the fall of 1998, a period that witnessed the demise of Long Term Capital Management and several other unfortunate parties that were active in emerging-market bonds, might have a different opinion. But this disastrous event only proved that problems at one financial institution can be transmitted to other institutions. After all, troubles at one money-center bank are almost always felt at every address on Wall Street.

The extreme heterogeneity of hedge funds supports the notion that alternative investments are too broad in scope to be considered an asset class. If that is the case, hedge fund investing should be considered a bottom-up exercise. An investor trying to decide between a number of convertible bond arbitrage funds, for example, should weigh firm information more than the return attributes of the strategy itself.

There are some exceptions to this rule. Trend-following futures funds tend to move more in lockstep with each other than do other hedge fund styles, and there are a number of indexes that capture the return of the strategy quite well. But considering the move by many large firms to a multistrategy platform, due diligence at the manager level will likely become an increasingly important part of the allocation process.


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