The hedge fund rebound could be short-lived—or then again, maybe not

Can hedge funds stay in the green?
Can hedge funds stay in the green?
Image: AP Photo/Richard Drew
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Hedge funds are set to do remarkably well this quarter. Data from consultancy Hedge Fund Research show that, in January and February alone, the average fund was up 2.7% (paywall), and the average equity-focused fund was up 4%. That’s about half of the gains the average hedge fund manager saw in all of last year: Funds returned just over 6% for all 2012, and lost 5% in 2011. Even if this year’s spectacular returns turn out to be short-lived, they signal a secular change that could keep the hedge-fund business an attractive outlet for investment.

Hedge funds generally do well when markets rally, and when they can bet successfully against the market consensus on specific companies. Although funds had a great year in 2009 when the S&P 500 rallied 23.5%, since then markets have slogged along, more or less moving in tandem with central bank decisions and politics. Last October, when the S&P was up 16% on the year, we calculated that it was down overall if you subtracted gains from Apple and on the days central banks made decisions.

This has been deeply vexing for hedge fund managers. With better information about the fundamentals than your average retail investor, they are often  cautious about piling into rallies they think are unwarranted. Chief among their concerns: 1) unanswered questions in the euro zone and 2) fear about growth fueled primarily by central bank measures, which have to go away one day. But as a result, they missed a lot of rallies in 2012.

However, a rising tide lifts all boats. Record gains so far this year suggest that, even when they miss the rally and produce less in the way of returns than would a basic stock index, hedge funds could still be in the black.

Looking forward, many are skeptical that the S&P 500 will hit new highs indefinitely. “There was definitely a moment in the first quarter of last year where it felt like things were picking up,” Luke Ellis, president of The Man Group, the world’s second largest hedge-fund manager, told the Financial Times (paywall). “And then look what happened. There was definitely a moment like that in the first quarter of 2011 too.”

Despite poor returns, there’s plenty of reason to believe that hedge funds are rebounding, though. They can thank governments for that. In the US, the Volcker Rule—which limits the kinds of trading US banks can do and the funds they’re allowed to sponsor—means that money is starting to move outside banks to non-bank financial institutions like hedge funds and private equity firms. This means that, even if betting on markets is getting harder, hedge funds will be managing bigger piles of assets, giving them more to make a profit on.