Hedge funds keep their heads down in bumpy markets

LONDON Mon Jul 19, 2010 12:17pm EDT

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LONDON (Reuters) - Hedge funds have cut back their bets over a volatile summer for financial markets, worried that big swings in investor sentiment are playing havoc with their carefully-researched trades.

What managers call the "risk-on, risk-off" trade -- where calling a sudden switch to bearish or bullish sentiment is more important than picking undervalued stocks -- has become critical as fears over a double-dip recession suddenly grow or recede.

But it has also led to sizeable losses for some funds.

While some commentators argue equities are cheap, Britain's FTSE 100 .FTSE index has nevertheless dropped from more than 5,800 in April to less than 4,800 at the start of this month, catching out many long-short equity funds, which tend to be biased toward rising prices.

Macro funds, meanwhile, have been hit shorting the Japanese yen, which has risen against the dollar since early May as investors sought out safe havens, and the euro, which earlier this month began recovering from a six-month bear market that was driven by sovereign default concerns.

"There's no point being a stockpicker right now," said one prime broker who declined to be named in order to speak candidly.

"Liking a company and being right about it is a joke if the world's ending," the broker said, adding that borrowing by equity hedge funds to finance long and short positions had come down since its recent peak at the end of April.

FUNDAMENTALS

Many hedge funds had built up exposure to equities during the first four months of the year, confident that in-depth stock research would pay off after 2009's bull market, when deciding to be bullish was more important that picking the best stocks.

"Many hedge funds tend to be fundamentally-driven... Overall they like 'this is a good situation' or 'this is a bad situation'," said Morten Spenner, chief executive of fund of hedge funds firm International Asset Management (IAM).

"Throughout 2010 there's been an inherent wish to increase exposure to markets, feeling fundamentals will come into play -- the idea you're able to research a situation."

However, the CBOE volatility index .VIX spiked in recent months, reflecting conditions that hedge funds are often seen as favoring but which, in reality, few care for.

After losses of around 3.5 percent in May and June -- and a loss of more than 6 percent from equity long-short funds -- according to Dow Jones Credit Suisse, many managers are keeping their heads down and waiting for stocks to start moving on what they perceive to be their fundamentals.

"Several (U.S.-focused) managers reacted to the bear market by raising cash and reducing their net long exposures to equities," said analysts at Lipper, a Thomson Reuters company.

Jose Galeano, chief investment officer of 3A, which runs fund of hedge funds ALTIN (ALTN.S), told Reuters he has invested with equity managers who looked at market sentiment and not just a company's fundamentals.

"Equity long-short are having some difficulties in reading the market, which is being driven by sentiment and liquidity rather than fundamentals," he said.

He said one Asia-based fund he had recently visited "had low net, low gross (exposures)... They're just waiting until they see more signals."

WAIT AND SEE

While funds are not as cautious as in autumn 2008, at the nadir of the credit crisis, leverage has fallen in recent months and funds are wary of big bets on market direction for fear of further losses.

"Hedge funds are not leveraged up. Right now hedge funds have very small directional longs and they're terrified of being directional short.. Exposures are way down," said Robert Marquardt, founder of fund of hedge funds firm Signet.

Funds that have done better have been those with a more pragmatic outlook.

"One manager was cautious in 2009 and made no money, they went into 2010 bullish and then saw the psychology of the market (and went short) and they're up 10 percent," said IAM's Spenner.

He has recently increased exposure to long-short credit managers. "Managers have been better than their equity peers at calling some of the (market) psychology."

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