Slumping returns, allegedly due to burgeoning capital flows chasing scarce market opportunities, were a prominent theme in the press coverage of hedge funds during 2004, at least for the first three quarters. It is true that record amounts of money poured in, yet at the same time markets were behaving mighty strangely. Strategies such as global macro, managed futures, and long-biased long/short equity were particularly hard hit by a lack of volatility or trend, and in all likelihood would have shown lackluster returns regardless of asset inflow.

All hedge fund indexes revealed a falloff of returns from 2003 to 2004. More interestingly, there was a wide dispersion among strategies, with certain sectors, like distressed debt, showing strong performance. This pattern supports the argument that the special economic and political conditions of 2004 had at least as much an effect on returns as the money flowing into funds.

It was a tough year, admits Michael Mikytuck, managing director at PlusFunds in New York, which creates tracking vehicles for the S&P Hedge Fund Index. Despite the overall poor performance, there was a wide variety of returns among different segments, he notes, with strategy-level returns ranging from losses of 3% to 4% to gains of 6% or more.

Many industry observers disagree with the notion that hedge funds are losing their edge as too much capital crowds the markets. Instead, they argue that the more people trade in the market, the more volume there is, the more liquid markets will become, and the more pricing anomalies and opportunities that will arise.

Raphael Douady, Riskdata’s New York-based research director, does not accept the “overcrowding” explanation. He believes underperformance is due to particular market conditions that specifically impinge on alternative strategies, rather than excessive asset growth. According to Douady, a double phenomenon has occurred. First, there has been a substantial break in trends in currencies and interest rates. Second, markets have shown abnormally low volatility and high correlations.

These factors have particularly affected commodity trading advisors and market-neutral strategies, as well as other hedge fund portfolios. Although money is likely to continue to flow into the industry, there is no reason to expect that current market conditions will last and hedge fund returns could revert to their previous levels.

PlusFunds’ Mikytuck reaches a similar conclusion. He finds little evidence of overcrowding, and instead argues that there is no clear direction in any of the markets. If there were, he says, money coming in would bid up prices of instruments so as to boost underlying markets.

“We’re less of the belief that it’s caused by excess capital and more that it’s caused by the low level of volatility in most markets,” he says of the last year’s performance.

The 2005 Forecast

Equity markets may produce returns this year at a level about half of their 2004 performance, tipping greater investment into alternative asset classes such as private equity and hedge funds, a Mercer Investment Consulting survey of 33 global investment management organizations found.

Alternative investments are still expected to do well over the course of the next five years. More than three quarters of the global managers surveyed said that private equities and commodities would produce the highest five-year returns through December 2009, with hedge funds ranking third in performance.–Jeff Joseph

Jeff Joseph is managing director of Rydex Capital Partners and serves on the advisory board of HedgeWorld (www.hedgeworld.com), a global provider of hedge fund information and investment products.

Have a hedge fund question? Contact Jeff Joseph at jjoseph@rydexfunds.com.

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