Hedge funds learn to profit from higher volatility

By Laurence Fletcher - Analysis

MONACO (Reuters) - Hedge fund returns look set to pick up this year after a poor start, as managers learn the painful lessons of recent months and feel well positioned to profit from opportunities arising in credit and equity markets.

Having cut back the leverage that caught out some funds last year and rebuilt computer-driven models hit by a vicious circle of selling last summer, funds now see opportunities amid high market volatility and a greater chance of corporate default.

Speaking at this week's GAIM International 2008 hedge fund conference, high-profile manager John Paulson said he sees a $10 trillion opportunity appearing in distressed debt and good value in higher quality mortgage debt.

Others hope to profit from forced selling of equities or better conditions for convertible arbitrage.

"If everything has been written down on the credit side, it's a great opportunity ... It's all about a lot of dumb people and a few smart ones," said Bill Browder, chief executive of Hermitage Capital Management.

During the first quarter, in which a sharp market reversal after the Fed's bailout of Bear Stearns Cos Inc caught out many funds, the Credit Suisse/Tremont index of hedge fund returns was down 2.01 percent.

While outperforming the MSCI World's .MSCIWO 9.5 percent fall, this was well below what investors might expect from an absolute return-focused asset class.

However, recent data suggests funds are starting to get used to post-credit crisis market conditions.

In May the Credit Suisse/Tremont index jumped 2 percent, its biggest gain this year, helped by strong performances from long/short equity, emerging markets and event-driven funds, pushing the index back into positive territory year-to-date.

"We're just beginning to see a fun market for stock pickers," said Renaud Saleur, an equity long-short manager at Jabre Capital Partners, who expects to profit from a renewed wave of forced selling by investment funds seeing redemptions.

Convertible arbitrage managers, meanwhile, are spotting some of their best opportunities in years, with returns set to match those that came after credit selloffs in 2005 and 2002, thanks to ideal conditions of high volatility and wide credit spreads.

GOOD OPPORTUNITIES

Even quantitative, or computer-driven, funds -- which were hit last July and August by a vicious circle of deleveraging in an overcrowded sector -- are feeling more optimistic that the quant fund space is less crowded than a year ago.

"I do think we can find good opportunities going forward in the quant space," said Robert Litterman, managing director of quantitative resources at Goldman Sachs Asset Management. "We're feeling much better than we have for a long time."

However, the biggest profits look set to come from distressed debt where Paulson, who made $3.7 billion in 2007 from shorting subprime according to Alpha Magazine, sees a $10 trillion opportunity emerging in the next six to 24 months.