CHICAGO (HedgeWorld.com)–A new day is dawning in the hedge fund industry, and this time it has nothing to do with the Securities and Exchange Commission or pension funds.
Hedge funds themselves are looking to reinvent the way they operate. Strategies that were the hardest hit in 2005, such as long/short equity, equity market neutral and convertible arbitrage, could ultimately be replaced by activist investing, special situations investing and capital structure arbitrage in the coming years.
“Traditional strategies have been arbitraged to death,” said Izzy Nelken, president of Super Computer Consulting Inc., Northbrook, Ill.
Comparing the rise of hedge fund strategies to the frontier spirit of the Wild West, Mr. Nelken said those who went west first were the ones who struck gold. Those managers that made it early on now need to move farther “west”–i.e., to new strategies or to new locations, such as emerging markets of Eastern Europe and Asia, as a stream of pioneer wagons rolls along behind.
Some of those exploring the hinterlands are looking at opportunities in capital structure arbitrage as a way to take on more measured levels of risk and profit and loss. Capital structure arbitrage involves taking long and short positions across the credit, stock and volatility spectrum, typically in instruments of the same issuer.
David E. Kuenzi, head of risk management and quantitative research at Glenwood Capital Investments LLC, Chicago, has observed a move by some managers to take on more market exposure coupled with a trend of long-time hedge fund strategies evolving into new strategies.
“Our analysis shows that both equity hedge and equity market neutral managers are taking on more market risk to combat low volatility,” Mr. Kuenzi said.
Price movement in the stock market hit an all-time low in 2005, so it makes sense that taking more long positions may be a profitable place to be in the near term. Some point to the increased market efficiency hedge funds have added as a cause for this condition.
In a recent research paper, “Superstars or Average Joes,” Harry M. Kat and Helder P. Palaro of London’s Cass Business School found that only 17.7% of 1,917 hedge funds were able to beat their benchmark.
“Over time, we observe a substantial deterioration in overall hedge fund performance,” the researchers wrote. “In addition, we find a tendency for the performance of successful funds to deteriorate over time.”
Managers’ dwindling returns have been blamed on the influx in recent years of hedge fund capital and overcrowding in certain strategies.