Morningstar Advisor - Spring 2007 - (Page 26)

Spotlight: Hedge Funds 6. Getting Duped by an Impeccable Bear In theory, hedge funds should outperform long equity portfolios during bear markets. And many hedge funds turned in stellar relative performances during the bear market in the early 2000s and into the bull market that started in 2003. While some of this success can be attributed to those funds’ hedged exposure during the downturn, we also believe that many hedge funds found themselves in a potentially once-in-a-generation environment. First, small-value equities ruled the day. Many hedge fund strategies involve investing in small-cap, value-oriented equities, either through fundamental research or technical trading, some of which is based on academic research showing that small-value stocks outperform others over long periods of time. Those securities performed exceptionally well, virtually across the board, in the early 2000s. One reason for this outperformance was that small-value stocks had been sorely neglected in the Nasdaq run-up in the late 1990s and then came back into vogue as the market pummeled Internet stocks. Small-value mutual funds performed fabulously well, relative to the broader market, in the early 2000s. Second, emerging markets and riskier assets in general—two areas that hedge funds are known to frequent—soared between 2003 and 2005. Virtually any investor that took on diversified risk made money during this period, without much regard to expertise. This is reflected below not only in the chart of emerging market returns versus the S&P 500, but also in the spread between U.S. high-yield bonds and U.S. government bonds. This spread rose to high levels in the middle of 2002 and dropped precipitously for the next two years, indicating that relatively risky strategies got paid off handsomely during that period. Third, hedge funds that engaged in carry trades—borrowing money at cheap rates (for example, U.S. Treasuries during this decade) and investing that cash in higher-yielding assets—benefited from low, and falling, shortterm U.S. interest rates. Some also benefited from the tightening of credit spreads, depending on which higher-yielding assets they chose for deploying their cash. Furthermore, investors dabbling in currency carry trades (for example, borrowing U.S. dollars and investing in higheryielding currencies) additionally profited from the falling U.S. dollar between 2002 and 2004 (shown below against the euro, as a fairly representative counter-currency). One hedge fund manager described these events as a perfect storm and warned that investors should not expect a period of outperformance like that in the early 2000s any time soon. Do not expect all fund managers to be so candid. This caveat is not meant as a knock on hedge funds. Instead, it is intended as a reality check. Because the investment records of many current hedge funds don’t extend much before 2000, some investors could be incorrectly led to expect a repeat performance of the early 2000s the next time the market stalls. Going forward, many market observers predict that hedge funds will be more prone to deliver lower- The Hedge Fund Perfect Storm 1 Small-value equities ruled the day. 2 Emerging markets soared in 2003 and 2004. Many hedge funds turned in stellar performances during the five years that began with the bear market of 2000–2002. These funds found themselves in a potentially once-in-ageneration environment. Small Value vs. S&P 500 Emerging Markets vs. S&P 500 Cumulative Return Small Value 186.21% Cumulative Return Emerging Markets 119.86% 8.15% 00 01 02 03 04 05 06 00 01 02 03 04 05 06 8.15% 26 Morningstar Advisor Spring 2007

Table of Contents Feed for the Digital Edition of Morningstar Advisor - Spring 2007

Morningstar Advisor Spring 2007 Features Departments Letter from Joe Mansueto Get to Know Morningstar’s Fund Managers of the Year Is Your Client a Stock or a Bond? Less Alpha, More Beta Than Meets the Eye Your Mileage May Vary A Clear-Eyed Look at Hedge Funds Lower Risk, Higher Returns, What’s Not to Like? Without Cash and Clout, Advisors and Clients Get Short End of Stick Get the Strategy Minus the Headaches Analyzing Funds of Hedge Funds Not All Hedge Funds Are Created Equal A Fund with a (Long) View Laying Low and Prospering A Menu of Ideas to Fill Five Market Baskets Oil and Gas Gushing with Values Mutual Fund Analyst Picks Undervalued Stocks Most Popular Variable Annuities What’s New at Morningstar and on the Web You Can’t Always Get What You Want

Morningstar Advisor - Spring 2007

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