The listed hedge fund sector was tipped for a revival in 2010, as a less challenging trading environment and sharp thinning of the ranks should have meant the strongest trusts – those able to survive the liquidity crisis of 2008 – were free to bring home healthy returns for investors.
Unfortunately, this has turned out to be an overly optimistic view, as after suffering losses in the summer of 2010, fund of hedge funds collectively scraped annual returns of just 5%.
As a consequence, investor confidence in the sector has remained low and inflows into listed hedge fund vehicles have failed to return to pre-crisis levels.
‘Investors are seeking capital protection and steady returns with with low correlation to equity and bond markets,’ Numis’ Ewan Lovett-Turner explained. ‘Most of the sector has failed to deliver in this regard, and investors have also been deterred by discount volatility and poor trading liquidity.’
After the financial meltdown of 2008, similar concerns, albeit heightened by broader worries about markets and the general economy, triggered an exodus of investors from the funds, draining them of a collective £1.7 billion over the 12 months to September 2009.
Discounts have since remained wide, averaging at around 15% according to Numis data. But opportunities in the sector do exist, analysts argue, pointing out that action by activist investors and a flurry of continuation votes should eventually see discounts tighten.
Stick to big ‘blue chip’ names
There are roughly 11 listed hedge funds expected to hold continuation votes this year and given the disappointing returns across the sector, investors may be at the end of their tether and feel reluctant to support continuations. ‘[This was] illustrated by FRM Credit Alpha falling its vote,’ Lovett-Turner said. ‘This puts greater pressure on funds to return capital through share buybacks and tender offers.’
Equally, activist investors quietly building up large positions in funds can have a similar effect on the number of vehicles populating the sector, and trusts including Dexion Capital have proposed a wind-up after value investors piled in.
But as Lovett-Turner points out, there is still demand for listed hedge funds, as fund raising ventures by BlueCrest AllBlue, BH Credit Catalysts and CQS Diversified funds pulled in a total of £607 million. Demand even exists for funds subject to corporate action, shown recently when Electric General’s share price pricked up roughly 15% after its wind-up was proposed in November.
‘We believe there are opportunities to exploit value in the listed hedge fund sector. Buying a fund for potential wind-up is complicated by the illiquid nature of underlying portfolios. As a result we favour large, liquid fund of hedge funds that can return capital while retaining meaningful trading liquidity,’ Lovett-Turner said. ‘We believe there is potential for Dexion Absolute (13% discount) to hold a reserve tender during Q1 in order to gain support for the continuation vote. We also believe Absolute Return Trust looks attractive on a 17% discount.’
Charles Stanley’s Stephen Peters also believes there are stand out listed hedge funds that have proved the model can perform, even if the broader sector has endured a rough 24 months.
‘I don’t recommend the sector but there are very good specific trusts within the sector,’ Peters said. ‘My general view is that in most cases these [trusts] struggle to justify their fees in terms of share price and NAV, and they don’t justify their absolute return mantra.