Global View

By Nick Evans

This year has been exceptionally turbulent and uncertain, clearly not a vintage year for long-short equity — especially not in Europe.

For several individual hedge funds it has been borderline disastrous — with some down as much as, or even more than, the markets themselves after a thoroughly rotten third quarter. For a notable few it has provided the chance to shine in the toughest of circumstances, and those who prospered through the chaotic markets of July, August and September should be amply rewarded by investor inflows.

But for the vast majority, it has been a hard and unrewarding slog, with stock picking, both long and short, proving almost impossible at a time when equity markets are in the grip of whipsawing macro sentiment and when fundamental valuations appear to count for very little.

Overall, the correlation with equity markets is ticking up, which is the last thing that investors want to see. And the universe of funds that can point to truly consistent success at uncorrelated returns, capital preservation and outperformance is shrinking.

So is long-short equity somehow broken? Could it be the case — in such a febrile risk-on/risk-off market where conviction is dangerous, where leverage is reduced, where short-selling bans curb flexibility, where the macro mood is prone to sudden and savage swings, and where the penalty for being wrong is far higher than the reward for being right — that long-short equity just doesn’t work?

That would be an overly generalized and simplistic conclusion. Overall, the EuroHedge long-short European equity index was down by some 5 percent through the third quarter, against markets that had fallen by some 12 percent over the same period (and which were down by some 20 percent in the third quarter alone). That does represent a creditable degree of downside risk protection and relative outperformance, underlining that managers are, in aggregate, doing their job for investors whose long-only portfolios are doing far worse.

Of course, hedge funds were not supposed to be about relative returns. It was a desire to get away from a long-only culture where losing less than the market was deemed to be acceptable that drove so many managers into long-short investing in the first place.

But human nature being what it is, relativity is never far away, and it is that relative outperformance, which so many managers scoffed at in earlier and perhaps easier times, that may now prove to be their savior and chief selling point.

Over a longer time frame, the relative outperformance argument stands up even more powerfully. And there cannot be many investors left who are not painfully aware that if they had invested much more of their money in long-short equity funds rather than long-only funds over the past ten years, they would have substantially more of it now than they do.

For institutional investors charged with funding long-term liabilities, that is a very compelling argument, and one that can no longer be ignored. But it holds true for every kind of investor. By dampening volatility, mitigating tail risk and avoiding the large capital losses that kill compound returns, long-short equity does truly add value.

So, far from abandoning long-short equity funds, many investors are now questioning if now is the time to put all of their equity investments into long-short funds and to end the nonsensical split between long-only equity and hedge funds (as if hedge funds were somehow a separate asset class, rather than a style of managing money).

Of course, there are investors in funds down 20 percent or more this year who are questioning the value proposition of long-short equity. But distinctions will be drawn between those that can show good performance over time and can clearly explain their drawdowns — who will probably be given another chance — and those that can’t, who almost certainly won’t.

There will doubtless be some heavy recycling of assets between funds that have coped well with this torrid time and those that haven’t.

For long-short equity as a whole, market correlations cannot afford to rise much further without serious questions being asked about the fees compared with the long-only world. And it is questionable whether 2 and 20 is really the price investors are prepared to pay for long-short equity these days anyway.

But the strategy is not dead. On the contrary, what appears to be a very bad and worrying year may actually turn out to be the start of a major change in investor attitudes in favor of, rather than against, the long-short model. But the price may need to change. AR

Nick Evans is editor of EuroHedge, a publication of HedgeFund Intelligence. A version of this column first appeared in that newsletter’s October 2011 edition.

Neil Wilson

To many in the European hedge fund world, it was simply incredible that the SFO would not be bringing charges against either Peterson or his associate Edward Platt, a senior employee at Weavering, on the basis that there was “no reasonable prospect” of securing a conviction.

The firm’s principal Cayman-domiciled vehicle, the Weavering Macro Fixed Income Fund, purported to have assets of more than $530 million at the end of 2008, after reporting profits throughout the financial crisis.

However, in early 2009, the fund was suddenly unable to pay out redemptions, leading to the discovery that its actual net asset value was far below what it had been declaring. The fund went into liquidation in March 2009, with investors suffering losses now thought to be $500 million or more.

The SFO moved quickly to arrest Peterson and Platt in early 2009 and to investigate certain derivative transactions, thought to be interest rate swaps, that the fund had entered into. Reports suggest that these transactions had not been executed with a recognized ISDA swap dealer but with an obscure British Virgin Islands company that—surprise, surprise—was controlled by Peterson himself. These transactions had the effect of inflating the NAV of the fund and covering up substantial losses Peterson had incurred in options trading.

This widespread astonishment over the SFO’s decision came just days after a court in the Cayman Islands took a landmark civil action against the two nonexecutive directors at Weavering—Peterson’s younger brother, Stefan, and his elderly father-in-law, Hans Ekstrom. In Cayman, a judge reached the damning conclusion that the nonexecutives were guilty of “wilful neglect” and awarded damages against them of $111 million each.

If a court in Cayman is capable of taking such a decisive action against nonexecutive directors, why can the SFO seemingly do nothing against the same firm’s full-time executives? Could Cayman actually be a tougher jurisdiction than the UK?

These questions may seem ridiculous to ask of the UK, where the hedge fund industry has been relatively scandal free. As I have argued consistently over the years, the system of regulation for hedge fund managers operated by the Financial Services Authority has generally been effective. Unlike in the U.S., where there has been a long litany both of blowups (from Long-Term Capital Management to Amaranth) and egregious frauds (from Manhattan to Madoff), the UK has seen few of either.

But Weavering does appear to be an important exception. It has always looked like a pretty open-and-shut case of fraud, which is why the SFO’s sudden abandonment of any action has caused such alarm.

“The SFO’s decision is particularly surprising given the weight of evidence, the proximity of the civil trial and the fact that, in related proceedings, a Cayman Islands judge has already found that Mr. Peterson defrauded Weavering’s investors,” said Barnaby Stueck, a partner in the law firm Jones Day, in a statement. Jones Day is representing the liquidators of Weavering Capital and bringing a civil action against Magnus Peterson and others, alleging fraud and breach of fiduciary duty. Stueck added, “Despite the SFO’s stance, Weavering’s investors intend to do everything possible to ensure a criminal prosecution takes place.”

Without access to the fine details of the case, which will probably not come to light until the civil action goes to court, it is impossible to know on what grounds the SFO felt it could not secure a conviction. This has led to speculation about what rights in the firm’s partnership structure or fund documentation would have allowed the managers to mislead investors about the performance of the portfolio and get away with it.

Industry consultants like Jerome Lussan of Laven Partners have highlighted the continuing importance of the caveat emptor principle in

all investments—and doing your own due diligence on a fund’s documentation as well as its operations.

Nonetheless, one is left with the feeling that had such a case occurred in the U.S., the authorities would still have found a way to prosecute the Weavering managers.

While the FSA regime has generally proved successful at preventing fraudsters from setting up hedge funds from the UK, the SFO—supposedly the UK’s main agency for investigating and prosecuting financial crime—continues to suffer from a reputation as something of a lapdog watchdog. The Weavering case does nothing to change that.

With markets going through yet more gyrations—sparked partly by the S&P downgrade of U.S. Treasury securities and amid recurring concerns about European sovereign defaults—many investors will no doubt have spent an anxious August holiday. Many will have been thinking: Are we about to witness a rerun of late 2008?

It is not a pretty thought. Last time, after Lehman’s collapse, a complete meltdown was averted only by a huge bailout of the banks by Western governments. This time, the governments themselves are teetering, and nobody, it seems, has the resources to bail them out.

For the hedge fund industry, 2008 was in many ways an annus horribilis. It was a year when the HFI Composite median did not look that bad (down only about 7%) but when mean average returns were down more about 15% to 20%. And it was a year when many individual funds angered investors by gating or suspending redemptions.

Yet 2008 was also a year—as I argued strongly at the time—of many heroic individual performances. A significant minority of funds were up, including some in almost every strategy area. For instance, Brevan Howard’s flagship macro fund—the biggest hedge fund in Europe with assets of more than $20 billion—delivered a terrific return above 22%. And Horseman Global Fund, then one of the world’s biggest global equity funds, gained more than 31%.

In 2008, one strategy in particular—managed futures—demonstrated a true capacity for noncorrelated returns, with the average CTA rising an impressive 15% to 20%. Many were up by a lot more, led by funds like BlueTrend, the BlueCrest Capital Management systematic strategy, which gained more than 44%.

Overall, hedge funds were down in 2008, but with returns still much better than the equity markets (which fell about 30% to 40%).

In 2009, performance was also pretty strong. Having protected investors from at least some of the downside in 2008, hedge funds also captured most of the recovery, with the HFI Global Composite median up by more than 12% (and mean average returns closer to 20% if you exclude the CTAs). In 2010, returns were not so exciting but again pretty respectable, with the HFI Composite median at close to 8%.

The most disappointing period of performance, arguably, came most recently, during the first half of this year, when hedge fund returns on average were more or less flat. In that period, hedge funds delivered little or no absolute return and did not outperform equity markets either, as many managers appeared to get repeatedly wrong-footed by whipsawing patterns in the markets. That left performance so far this year looking uncomfortably similar to 2008, when hedge funds also had a flat first half, which led into six straight months of negative returns that year (from June through November).

In short, the markets—and returns so far this year—do not look pretty. Just how tough it has been is perhaps best reflected in reports that even George Soros, arguably the most talented fund manager in history, had liquidated most of his positions, even including exposure to gold, and gone mainly to cash.

On the other hand, where there is great difficulty, there is also opportunity. And if markets do go through another period of upheaval and convulsion, hedge funds should get a chance again to shine, just as in 2008, when a significant minority truly did deliver.

One might expect that some of the same sorts of strategies that worked in 2008—such as the CTAs, global macro and volatility players—would work again in similar circumstances. But if there are sovereign defaults, then there may be new and unforeseen sorts of market dislocations.

However, there may also be other strategies that excel next time—including long/short equity funds and/or credit, distressed debt and multistrategy hedge funds, who may well be able to seize a “once-in-a-lifetime” opportunity.

I do not dare to predict who will do well. That is more properly the job of professional allocators, including the funds of funds, who may also have a huge opportunity to prove their worth (and in some cases, redeem themselves after a poor 2008) by picking the winners in the coming period.

It does look like a rough ride ahead. It could be a crucial test not merely for hedge funds but for the whole western system of capitalism. After so many crises and major market events—from the dot-com bubble to the Lehman collapse—this sovereign debt crisis could prove to be the ultimate stress test.

Nevertheless, I still firmly believe that there are hedge fund managers who can and will demonstrate the ingenuity and skill to navigate through this period ahead. It will be very interesting to see how many can do it and which ones they will be.