Should you still back hedge funds?

So much for all the promises about being able to make money in any market. Last month, every single hedge-fund strategy lost money, according to Hedge Funds Research (HFR). The average fund finished the month down 2.26% or 2.99% if you use the Hennessee Hedge Fund Index. Some individual funds fared far worse: respected brands such as Moore Capital, Odey Asset Management and BlueCrest posted losses of up to 10%. This was the worst collective performance since November 2008, just after Lehman Brothers collapsed. So what went wrong?

Where it all began

The original hedge fund was set up in 1949 by an American, Alfred Winslow Jones, with four friends. He adopted two ideas that form cornerstones of many hedge-funds strategies: leverage, or borrowing money to enhance returns; and short selling, the technique of making money from falling share prices. Used conservatively and alongside traditional 'long-only' buy-and-hold investing, Winslow applied the two techniques to enhance returns. Since then the industry has ballooned and there are now thousands of funds offering more than 30 different strategies, judging by HFR classifications. Some of the popular methods are listed in the box below.

The month the sky fell in

So why did everything go pear-shaped in May? As Tim Price, director of investment at PFP Wealth Management, notes, as the hedge-fund industry has grown, "the prevailing trend over recent years among hedge funds is that they all almost independent of strategy have become more closely correlated to the stockmarket".

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May was a terrible month for markets across the globe. Jitters about the eurozone, the one-day 'flash crash' in New York, and disappointing jobs data in America combined to hit stocks everywhere. So no one had a good month in May.

But what's more disconcerting, says Price, is that according to Hedgeindex.com, funds that claim to have a dedicated 'equity short'

bias (that is, they're meant to make money mainly from falling stockmarkets) "have delivered the worst returns year-to-date". That's a little odd at a time when equity markets have done pretty poorly across the globe.

What happened to the 'shorts'?

The explanation is twofold. Firstly, regulators have been making life tougher for short sellers. Recently the German government imposed a shorting ban on German-listed stocks and some credit instruments. Sure, a hedge fund can get around these bans by shorting the same stocks in a different market. Even so, government action adds a layer of political risk to an activity that's already pretty risky. More fundamentally, says Price, it shows that, despite the hype, "hedge funds evidently have as much difficulty in stock selection as 'normal' investors" do. So how do you pick a winner?

Two funds worth watching

First, investors need to be aware that hedge funds have at times been their own worst enemies. The marketing, especially of expensive funds of hedge funds, suggests that you will never lose money, regardless of market conditions. "This is absurd and nave," says Price. The trick is to recognise this and then be selective. For a single manager fund he tips Brevan Howard's BH Macro fund (LSE: BHMG). This takes directional bets (similar to someone like George Soros) on interest rates and currencies. It is up 15% over the last year. As for multi-strategy funds, he likes BlueCrest's All Blue Fund (LSE: BABS). Its strategies include "global macro, emerging markets, trend following and credit trading" (see below). The fund is up around 2% year to date.

Five common hedge-fund strategies

Equity long/short similar to traditional funds. A fund is usually mainly long, but will also 'short sell' shares.

Convertible arbitrage profiting from mergers and acquisitions activity. A trader might buy a target and sell a predator in the hope of a bid arriving.

Or they might buy cheap convertible debt and sell the related shares short.

Macro driven the trick here is to spot how big economic and political events will affect exchange rates or the price of, say, a commodity, and invest accordingly.

Credit or debt arbitrage the aim is often to buy cheap bonds in a troubled firm, hoping to get a better price when it is restructured. When the target is debt issued by firms close to bankruptcy or nationalisation, it is often known as 'distressed debt' or 'vulture' investing.

Momentum or trend following 'the trend is your friend', as the saying goes, so a trader looks to spot, say, an exchange-rate trend forming early, then profit from the fact that they often last some time before changing direction. Charting is often used widely here.