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J.P. Morgan Report Sees Erosion in Some Hedge Fund Segments, Opportunities in Others

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LONDON (–A report that describes 2004 as “almost a perfect storm hitting alpha” for active hedge fund investors, with a number of factors coalescing to dampen returns, finds that while hedge funds offer ample opportunities for profit in many areas, some of the commonly used strategies are eroding the very market opportunities and mispricing on which hedge funds have relied to net high returns.

Describing the situation in the most basic terms, the report from J.P. Morgan Securities Ltd., states that opportunities “are disappearing fastest where hedge funds are very active” and “remain ample where there are fewer hedge funds.”

The report, written by J.P. Morgan market strategists Jan Loeys and Laurent Fransolet, analyzes the performance and potential of various hedge fund categories, in an attempt to answer the “big question” of “at what point are hedge funds so big that they arbitrage away the excess return opportunities they seek to exploit?”

Noting the soaring growth of hedge fund investment, the authors contend that prospects for outperforming traditional investments with hedge funds are dwindling “where there are deep derivative markets and where the same trading rules have been used for some time.”

The best opportunities lie in strategies where relatively few hedge funds exist, where derivative markets are well established, and where funds use new trading rules, proprietary trading rules or advanced analysis, the authors say. Thus, they note, in equities, anomalies and relative value have undergone significant erosion, dulling the luster of hedge funds in that sector. Similarly, in interest-rate markets, many of basic relative value opportunities have been lessened or lost. As a result, funds have moved to newer products and to “the interaction between volatility and rates to reach the next level in relative value.”

In credit, say the authors, mispricings in short-maturity, BB-rated credits and momentum trading remain, but increased use of credit default swaps could close out opportunities.

Currencies, according to the report, continue to offer promise. Even though hedge funds are heavily involved in currencies, the authors say that the size and diversity of participants in the foreign exchange market mean that the “age-old opportunities” of the carry trade and momentum are “alive and well” for hedge funds investors. They note that standard models have not fared well, but that innovative rules can achieve high returns to risk.

Reiterating that 2004 has been a challenging year for alternative investment vehicles, with a business cycle that saw few bouts of momentum and little volatility in equities and bonds, the authors conclude by saying, “We think it is too early to write off hedge funds.” Yet their skeptical outlook for some of the most popular strategies may extend into 2005, as they “find that most spread markets are close to fair value this year and that the cyclical factors imply little movement in these spreads this coming year.”

Last month, J.P. Morgan Chase’s Fleming Asset and Wealth Management division in New York announced it was buying the hedge fund manager Highbridge Capital Management, with about US$7 billion in assets under management, in a deal valued at over US$1 billion (see ).

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Contact Bob Keane with questions or comments at: [email protected]</a.


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