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May Was Good to Hedge Funds—But How's The Future?

Hedge funds posted their best monthly performance in a decade in May, taking advantage of rallying stock markets and distressed opportunities across the board, according to the latest numbers from the Absolute Return Composite of hedge fund indices.

The industry has been increasingly under the microscope by Washington and investors alike since the second half of last year. On top of registering their worst performance ever in 2008, with the average fund down 19 percent for the year, the $50 billion Madoff fraud delivered a severe blow to the already suffering industry and gave rise to a huge wave of redemptions.

But this year has been different. On average, hedge funds gained 3.1 percent over May, bumping up year-to-date gains across the $1.33 trillion industry to about 6.1 percent.

By comparison, the S&P 500 index is up 4.8 percent for the year so far.

Mortgage-backed securities funds reported their biggest monthly gains ever, up a median 10.3 percent for the month, possibly signifying rising investor sentiment towards stabilization in the housing market. Other strategies that performed well include U.S. long/short technology at 7.7 percent and convertible & equity arbitrage at 5.1 percent.

Amid increasing market turmoil and uncertainty in the financial sector, many marquee funds like Paulson & Co., Greenlight Capital and Eton Park had retreated from equities towards the end of last year, choosing instead to beef up their cash positions and seek out safe havens in hard commodities like gold. Last month's strong performance for the industry was a sign they are now slowly wading their way back in.

"After historical lows in 2008, risk appetite has quickly returned over the last eight weeks, suggesting that hedge fund investors are again looking past month-to-month volatility and focusing on the longer-term performance merits of the industry," said Kenneth Heinz, President of data provider Hedge Fund Research.

Others in the industry are not quite so rosy.

"The good returns in May must be put in context of the prior six months obliteration of most asset classes including equities...most hedge funds are just getting back a portion of the previous stock market losses, " says perennially bearish hedge fund manager Doug Kass of Seabreeze Partners.

"We've seen a 2,000-point run up in the Dow over the past three months," adds Carolyn Sargent, Deputy Editor of Absolute Return magazine, a unit of Hedge Fund Intelligence Ltd. "A number of fund managers think that the next 2,000 points will come much more slowly — and from more selective pockets of the market and thus are cautious about further gains."

According to HFR, outflows for the industry in 2008 were $154 billion though have now slowed to $103 billion through Q1. In an effort to limit the mass exodus, many funds put up gates restricting how much money (if any) they would allow investors to pull out in the near term.

Though criticized by many for their behavior at the time, this strategy may have proved meritorious for the funds and the investors themselves.

"An executive at a fund recently told me that had it refrained from exercising its right to employ a gate last year and liquidated necessary positions at the time, it would have received 17 cents on the dollar for those investments. Today those same investments are yielding them 41 cents, "says Leon M. Metzger, a noted hedge fund expert and adjunct professor at NYU, Columbia and Yale universities. "In this case, investors benefited from the gate, as the value of some of their investments more than doubled."

Though performance is picking up and fresh capital is starting to slowly trickle back in, the industry continues to face major challenges ahead. Some form of government regulation for the notoriously secretive industry is now clearly on the horizon and reputational risk is higher these days in the post-Madoff world.

Amid a reopened U.S. government probe into insider trading allegations at Pequot Capital, hedge fund industry heavyweight Art Samberg announced the decision to wind down his main fund last week.

Jimmy Pallotta of Raptor Capital Management and George Noble of Noble Partners, also both announced Tuesday that they would be winding down their flagship strategies. In a June 2nd letter to investors, Nobel stated “the hedge fund model has changed significantly” since 1991, when Noble first set up shop, and “in light of these changes, Noble Partners will be undertaking a process that we believe will result in a platform better able to take advantage of the opportunities presented.”

Says HFR's Ken Heinz, “following a period of consolidation, we expect industry growth to resume in the coming quarters, with an emphasis on transparent investment by institutional investors.” It appears that hedge funds, though not as superior investment vehicles as they once seemed, are definitely here to stay.