LONDON (HedgeWorld.com)–A report that describes 2004 as "almost a perfect storm hitting alpha" for active hedge fund investors, with a number of factors coalescing to dampen returns, finds that while hedge funds offer ample opportunities for profit in many areas, some of the commonly used strategies are eroding the very market opportunities and mispricing on which hedge funds have relied to net high returns.
Describing the situation in the most basic terms, the report from J.P. Morgan Securities Ltd., states that opportunities "are disappearing fastest where hedge funds are very active" and "remain ample where there are fewer hedge funds."
The report, written by J.P. Morgan market strategists Jan Loeys and Laurent Fransolet, analyzes the performance and potential of various hedge fund categories, in an attempt to answer the "big question" of "at what point are hedge funds so big that they arbitrage away the excess return opportunities they seek to exploit?"
Noting the soaring growth of hedge fund investment, the authors contend that prospects for outperforming traditional investments with hedge funds are dwindling "where there are deep derivative markets and where the same trading rules have been used for some time."
The best opportunities lie in strategies where relatively few hedge funds exist, where derivative markets are well established, and where funds use new trading rules, proprietary trading rules or advanced analysis, the authors say. Thus, they note, in equities, anomalies and relative value have undergone significant erosion, dulling the luster of hedge funds in that sector. Similarly, in interest-rate markets, many of basic relative value opportunities have been lessened or lost. As a result, funds have moved to newer products and to "the interaction between volatility and rates to reach the next level in relative value."
In credit, say the authors, mispricings in short-maturity, BB-rated credits and momentum trading remain, but increased use of credit default swaps could close out opportunities.
