The luck certainly seemed to have run out for equity markets on the third Monday of 2008. So what, exactly, is left?

The textbook suggests hedge funds. Now a $2500bn industry, they have trebled assets since the bear market of 2000-02 thanks to demand from institutional investors. Assets managed in hedge funds of funds, still institutions’ entry-point of choice, totalled more than $1400bn at the end of 2007, according to the Aite Group. Hedge funds have proved themselves over the long term and through bear markets. Since 1994, hedge fund indices have compounded 330-475 per cent, against the S&P500’s 306 per cent and the MSCI World Index’s 150 per cent; for 2000-02, MSCI World was down nearly 41 per cent, while hedge funds made about 8 per cent.

That track record should appeal to pension funds. The aggregate FRS17 deficit of the UK’s 200 largest defined benefit schemes stood at £2bn at the end of 2007, according to Aon Consulting. By the end of Monday, January 21, it had ballooned to £33bn after the biggest one-day increase on record. Mercer’s Tim Keogh surveyed the damage and showed a yellow card to the “minority of defined benefit schemes with weak sponsors and aggressive ‘stay-in-the-casino’ investment strategies”.

At least you can cash in your chips at the casino – it’s not an option if your liabilities necessitate a cash-plus target return. If, over the medium term, we see something like the 40 per cent drawdown suffered during the last bear market, investors will need to find some yield. Brighton House Associates tracks investor demand for hedge funds and the firm’s research analyst Michael Marolda says this “has never been higher”.

Albourne Partners, which advises more than 50 institutional investors including Caisse de dépôt et placement du Québec, Hermes Pensions Management and the Teacher Retirement System of Texas on more than $73bn worth of hedge fund allocations, also reports its longest-ever pipeline of potential clients. “With every other crisis, the big hedge fund traders couldn’t wait to be contrarian and the investors were scared to pour in money,” says Albourne managing director Simon Ruddick. “This time around, the investors can’t wait to be contrarian.”

But after a five-year bull market, not everyone remains convinced that hedge funds are contrarian. “A lot of investors see a Catch-22,” says Polly Smith, sales director with fund of funds manager PSolve Alternative Investments. “Funds of hedge funds do tend to have high beta exposures – just because about 85 per cent of the hedge fund universe is long-biased, with net exposure from 75 per cent upwards. But investors also perceive that, during the bull markets, hedge funds don’t perform as well as the market. In up-trending markets people have focused a lot on the manager risk – talking about due diligence processes, and so on – but management of market risk has probably been a bit lax.”

Investors will often look at historical correlations when considering how much market risk a particular investment entails. Towards the end of 2007, three-year rolling correlation between Greenwich Alternative Investments’ Greenwich Global Hedge Fund Index and the MSCI World Equity Index was 0.92. In 1995 it was 0.57.

Correlation conundrum

Few complain about rising correlation in a roaring bull market. But look at correlation with world equities during the last bear market: according to Greenwich: it went from 0.65 in September 2000 to 0.78 in September 2002 – an increase of 20 per cent. Correlation with the S&P500 jumped 78 per cent. That defies common sense: it was hedge funds’ capital preservation in that bear market that transformed them from a wealthy investors’ backwater to today’s institutional star attraction.

Correlation captures none of the returns outperformance, because it only measures the direction of the movement of two values relative to their own volatilities. To explain that, you must measure sensitivity by multiplying correlation by the ratio of the discrete volatilities of the two values. This – the beta of the Greenwich index against world equities – went from 0.45 in September 2000 to 0.28 two years later.

This is often what happens within fund-of-funds portfolios. Graham Martin is head of European sales at Optima Fund Management, which manages $6.3bn for a client base that is 70 per cent institutional. He notes that correlations have gone up, but the firm is focused on keeping its betas low. “That’s one of the reasons not to focus too much on correlations,” he says. “The beta on our long-short equity is below 0.3, whereas the correlation in the short term might be about 0.5.”

“How can beta go down while correlation goes up?” asks Margaret Gilbert, managing director at Greenwich Alternative Investments. “Because hedge funds decrease their volatility relative to the market, either by changing gross and net exposures or trading less volatile instruments.”

Glenn Baggley, chief executive officer at fund of funds manager Eddington Capital Management, points out that correlation data has specific periodicity, which could affect analyses.

“With hedge funds you’re typically looking at monthly data, so what you see is how correlated the hedge fund returns are to the market in any one month,” he explains. “So if you looked at a hedge fund’s monthly correlations for 2000-2003 and then 2004-2007, I’d be prepared to bet that the correlation would be quite similar, at 70-90 per cent.”

Timing is everything

The Greenwich data confirms that that was a safe bet. But Mr Baggley suggests that quarterly or weekly data would throw up very different correlations, precisely because “hedge fund returns bounce around in a completely different way from market returns”.

“Whether the monthly noise you get from hedge funds is similar to the monthly noise in equities is not what you need to know as an investor,” he says. “You need to know, if equities are down 50 per cent three years from now, whether or not hedge funds will be down 50 per cent. The answer is: no, they won’t.”

That is a beta question, not a correlation question. Each metric is useful for a distinct part of the portfolio construction process: correlation for achieving diversification; beta for achieving downside protection within the risk-exposed part of a portfolio.

“The stress-tests and scenario-analyses that our clients use are all beta-driven, not correlation-driven,” confirms Damian Handzy, chief executive of Investor Analytics, which works on risk management for both single-manager and funds of hedge funds. “The risk measures – things like VaR (value at risk), diversification measures – are all correlation-driven.”

Ultimately, focusing on beta can lead to a miscalculation of true diversification, while focusing on correlation can lead to a miscalculation of true market sensitivity. If you are looking for a non-correlated asset, beta is not the metric to use, and long-short equity probably not the strategy.

“The sources of returns for hedge funds are 80 per cent beta-oriented,” says Eric Bissonnier, chief investment officer at EIM, which constructs tailored hedge fund portfolios for institutional clients. “It’s always been like that. Market neutrality doesn’t really exist. You’re exposed to markets, to behaviour, to fear – you’re exposed to something, otherwise you’re in cash. The question is, What do we mean by ‘beta’?”

The answer, he suggests, is not really about net exposures, the simple ability to go short – it is about what you are willing to pay for. If you want to go long mining and short financials you can do that virtually costless with exchange-traded funds – that’s just beta.

“What you are unable to replicate is the ability of some managers to adapt,” says Mr Bissonnier. “Over the last four years we saw a lot of beta participation from hedge funds, but we think that will change going forward because the basic predicate of a hedge fund is to make money over time – not to outperform. If they lose money, they lose assets and lose their business, so there is absolutely no incentive for them to follow the market on the way down.”

Mr Ruddick agrees, arguing that transitions into new economic equilibriums are when hedge funds make their best money, irrespective of what the new equilibrium is.

“Because they have no enforced long bias or constraint within a certain type of investment, they’ve tended to be more nimble at working out what the new market condition will be,” he says. “We spend most of our lives managing down the hedge fund expectations of our clients, but even we are pretty optimistic that 2008 should be exactly the environment in which hedge funds can deliver.”

This ability – and incentive – to act without constraint is the key differentiator picked out by industry players, far above any quantitative indicators drawn from historical returns.

“Pension funds tend to assume that correlation and beta are static in their analyses,” says Mr Baggley. “That’s not a bad assumption for long-only strategies, but it is for hedge funds, where both change over time, particularly when you go from a bull to a bear market.”

It has been several years since we experienced that, and most of the long-short equity funds on the market have appeared in the meantime (so it should be no surprise if they exhibit average lifetime betas of 0.8).

“Has anything fundamentally changed in the way that long-short equity funds are being managed?” asks Mr Baggley. “No. But have market conditions changed this time around from what they were last time around? Yes. I suspect that this time around the market’s going to be particularly difficult to predict, so you really need to be pretty confident that your manager has his finger on the pulse, rather than his eye on the consensus.”

That confidence is Eddington Capital’s stock-in-trade: it runs three funds of funds (one multi-strategy, one equity-focused and one macro-focused), which back high target-return managers unafraid of directionality. Directionality can be long or short, of course, and whereas, over all cycles, the funds’ underlying managers average similar net exposures to their peers at around +80 per cent, they generate their excess returns – is it alpha, or super-smart betas? – by moving much more aggressively across a much wider spectrum, from -100 to +200 per cent.

Bearing in mind that each manager implements a distinct strategy, Eddington Capital’s long-short managers have generally been pulling back exposures for almost 12 months already. That’s not surprising: in 2003 the firm was already warning investors that any crisis of confidence in the credit markets would precipitate a bear market in equities.

Some great contrarian managers with a similar view made big money last year. But looking at the data behind hedge fund indices it seems that even when the averages and the duds are factored in, the aggregate picture is one of considerable activity.

Although net exposures across long-short equity managers in the Greenwich database showed no clear trend across any month in the fourth quarter of 2007, analysis of a small sample who provide daily data for the first 12 trading days of January, revealed “quite volatile” movements.

Adjustments

At HFR, where long-short equity shows a beta of 0.7-0.75 over five-year periods, predicted beta for the second half of 2007 comes in at 0.23-0.35, with the most recent results toward the lower end of that range. “I think it is fair to represent that the equity focused managers have slightly adjusted exposures to market conditions to reduce systematic equity exposure,” says HRF’s president Ken Heinz.

Mr Bissonnier of EIM – which is clearly active in manager selection, though more diversified than Eddington Capital – finds that 24-month rolling beta in his long-short portfolio was at around 0.9 between 1998 and mid-2000; falling to 0.1 by mid-2001; before beginning its move upwards in the beginning of 2004 to reach a new peak of 0.8 into the first weeks of 2007. Since then it has retrenched to 0.5 – and remember, this is a two-year rolling average: as we spoke, Mr Bissonnier’s long-short portfolio had lost only about a quarter of what the markets had given up, year-to-date. He estimates that current beta will turn out to have been around 0.2.

Although some will have capitalised dramatically on the month’s market volatility, on aggregate hedge funds probably won’t have made money in January. But November showed them starting to absorb the shocks, and there is evidence that long-short equity funds are positioning themselves aggressively for the new economic reality of 2008.

The time when institutional investors could conceptualise hedge funds as part of a diversified “alternatives” allocation is passing. Hedge funds are not an asset class. Each strategy set is a combination of alphas and betas that overlap, and can enhance, existing portfolio exposures. Long-short equity can complement an equity exposure with high correlation but very flexible beta; relative value and market neutral can replicate fixed income like returns with low correlation to bonds; and directional strategies can offer returns, correlated or non-correlated with the rest of your portfolio, by riding momentum up or down across any asset class – including volatility.

This latter strategy-set could be primed for outperformance after years without steam – and that is exciting because, while markets whip and heave about unproductively, these managers can post stratospheric returns.

Damian Handzy, chief executive of Investor Analytics, tells how the firm conducted some work on correlations between asset classes in 2007. It turned out that equities and bonds, on average, had zero correlation.

“But here’s the remarkable thing: it was never zero at any point in time,” he recalls. “It was either +0.8 – and it would stay there for two months – before flipping to -0.8 within days. Then two months later it would flip, again within days, back to +0.7. If you think that 5 per cent daily swings in the returns space is extreme, well, in the correlations space the shift was 200 per cent.” He thinks that funds of funds with a component of global macro, multi-strategy and CTA [commodity trading advisor] (the strategies that can trade pretty much anything and shift their portfolios radically, within hours) are those best able to navigate a regime change such as that from low volatility to high volatility.

“We’re not betting on the market going down,” says Eric Bissonnier, chief investment officer at fund of funds manager EIM. “The one bet we are making is that volatility will stay around for quite a while – that’s a source of return, but it means a lot of the equity strategies become less attractive.”

In August, EIM brought its 38 per cent allocation to long-short equity down to 30 per cent, redistributing the capital to distressed debt, multistrategy event-driven, volatility arbitrage and macro.

One can see similar moves across the fund-of-funds world. Graham Martin of Optima Fund Management says the firm has reduced long-short equity in favour of macro and CTAs.

“We think this is a good time to move into macro because we are moving from a sentiment-driven environment to a fundamentals-driven environment,” agrees Glenn Baggley of Eddington Capital. “The same goes for CTAs: we think we’ll see much more sustained moves and less violent reversals in a lot of the instruments those guys trade.” Messrs Baggley and Martin have both noted significant institutional interest in their firms’ funds of macro funds.

So one strategy for fund of funds buyers in 2008 could be to find managers who are avoiding short-vol strategies in credit; reducing long-short equity (and ensuring that gearing is light enough to allow nimble management of net exposures); and ramping-up macro and CTA allocations with managers with whom they enjoy longstanding relationships.

“The irony is that those are the strategies that pension plans hate,” observes Simon Ruddick of hedge fund advisory firm Albourne Partners. “To date, most approach asset allocation sequentially: they’re happy with whatever their allocation and exposure is to equities and bonds, and they are just looking to add hedge funds. That overwhelmingly results in non-directional, market-neutral type mandates, so they might miss out on some of the value that’s available from directional trading.”


GRAPH 1: HEDGE FUNDS AND THE 2000-2002 BEAR MARKET

GRAPH 2: HEDGE FUNDS AND THE 2000-2002 BEAR MARKET

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