Hedge funds are back and as vibrant as ever

Hedge funds are slowly making a comeback after a year in the cold.

Hedge fund obituaries were written a year ago, with many commentators deciding that after 59 years the sector should rest in peace. But akin to the rope-a-dope trick of the boxer Muhammad Ali, many are still on their feet, with the sector looking to end its 60th year in pretty good shape.

Investor confidence is by no means back to where it was in August of last year, and although the sector is no longer a US$2 trillion (Dh7.34tn) industry, it is a $1.4tn one. These days, returns are good and hedge fund businesses have developed for the better.I would go as far as to say that the hedge fund sector is as well placed today as it has been for a number of years. Like the rest of the world, the sector was starting to see some excesses. For a start there were far too many managers, some good and some not so good. The sector needed a clear-out and from the approximate 10,000 managers a year ago, there are now about 7,000. Those funds that closed, like the wider financial services markets, were running excessively leveraged or esoteric strategies and not long after Lehman Brothers's collapse were stuck in the quagmire of illiquidity. Others were operating in small, limited, markets, while others were pure momentum plays.

Many of the weak funds have now disappeared and while we are starting to see an increasing number of fund launches, there will be further fund closures, but this is all part of good housekeeping and maintaining an efficient system. This is a business of a few good managers, a mantra which has stood us well for many years, and will always be the case. Funds have had to change their business models to adapt to the new circumstances. Some now offer managed accounts, providing investors with their own separate portfolios, undiluted by the co-mingling with other investors. Funds now use multiple top-tier counterparties, and others have been forced to move to the more liquid end of the spectrum. Those funds that do not have the resources or ability to change to these new circumstances will not last.

Not surprisingly, investors are more wary today, but they are also more knowledgeable, much of which has unfortunately been borne from harsh experiences. Today, across every region in which we operate, we are seeing far greater due diligence from investors, from high net worth to institutional. From our side, it takes about six months to invest in a manager and that is with all the resources we have to hand. This is not because we are slow, it is because there are so many different aspects of their investment that we want to focus on.

What has not changed is the ongoing need for investor diversification and the importance of risk-adjusted returns. Hedge funds for all their sins, and the reams of negative press coverage, have still significantly outperformed the markets over 10 years. On a cumulative basis the HFRX Global Index's 10-year return is 70.3 per cent compared with minus 1.5 per cent for the S&P 500 share index and 4.3 per cent for the MSCI World through to the end of last month.

Hedge funds have been on the receiving end of a great deal of flak for being the cause of this crisis, due to apparent excess leverage, yet the leverage taken by hedge funds was not on the same scale as that of banks and have since been vindicated. Change is afoot on the regulatory side and this is accepted by all. Such a move will clearly benefit investors, including fund of funds. Hedge funds by their very nature should be dynamic and must be able to adapt to these changing circumstances. They will continue to develop their back offices and related services, while others may be forced to restructure, but the industry will in essence be the same.

Look at the world today and it is clearly in a far healthier state, with liquidity flowing once more and in certain markets even real estate is once more on the rise, but we continue to have the spectre of extraordinary fiscal deficits hanging over us. Since February, investors could have put their money in almost anything and they would have made money, but now the third quarter is over, the final quarter of this year looks far more challenging. Equity markets have had a great run, but the easy money has been made and we are now entering an ideal environment for the good hedge fund managers.

Hedge funds are there to make money for the investors and many did not last year. Last year was particularly difficult for the entire sector, but as this year continues and as the numbers improve, they are slowly but surely winning back investors.   Thomas Evans is the executive vice president of Permal Group. The views expressed in this article are those of Mr Evans and do not necessarily reflect the views of Permal or any of its affiliates.