Hedge Funds Brace For Uncertainty

By Aaron Levitt | October 14, 2012 AAA

When wealthy investors, pension funds and endowments need to juice their returns, they often turn to hedge funds to gain that boost. These aggressively managed portfolios that use advanced investment strategies - including leveraged, long/short and derivatives - have typically been a key way for institutional investors to generate high returns and seek alpha. However, they may need to find other ways to generate those big returns this autumn. Uncertainty remains the name of the game heading into the fourth quarter. A mire of global macro-economic factors are conspiring against investors and the normally aggressive hedge fund industry seems to be playing it safe. For regular investors, following the hedge funds' recent flight to quality could be a good idea.

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Cash, Gold and T-bills
Volatile markets and rock-bottom interest rates have crushed the returns of many hedge funds. It's been roughly five years into the financial crisis and while things have gotten better since the collapse of Lehman Brothers, there is still is plenty of uncertainty and general market risk to be had. The risk is causing many typically aggressive hedge fund players to bet heavily on stable assets such as gold, or sit on cash. Additionally, the percentage of leverage (margin loans or debt used to boost holdings) from the hedge funds remains at low levels. Reuters reports that the average hedge fund is only leveraged 3.4 times net asset values. That's far below the amounts seen in the pre-Lehman implosion days.

All in all, "safe" bets seem to be prevailing and there is certainly a reason to be cautious. That list of risk factors seems to grow every day. First, key emerging markets, like China and Brazil, continue to battle slowing growth. Emerging markets were critical in helping the globe return to relative GDP growth during the 2008-2009 downturns. As future growth leaders, any hiccups in the developing world will surely cause hiccups all the way up the food chain.

This point is exacerbated by the fact that the developed world is facing its own issues. Europe remains a mess with its debt issues continuing to compound. At the same time, the United States faces a plethora of political and debt issues of its own. Perhaps none as foreboding as the pending "Fiscal Cliff." That's the January deadline when $7 trillion worth of tax increases and spending cuts will automatically happen - assuming congress doesn't act in time. That "cliff" could have a severe effect on the global economy. With these factors in mind, the IMF recently downgraded its 2012 forecast for global GDP growth to just 3.3%, with 1.3% growth predicted for developed market economies and 5.3% in the emerging world.

Getting Defensive
Given all of these woes facing the global economy, it's no wonder why the hedge fund industry has braced for slowing times ahead. For us regular Joes, that might not be such a bad idea. Marketplace.org reports that hedge funds have been loading up a variety of safe-haven assets during the last few months of the summer. These include gold, short-term bonds and cash. The SPDR Gold Shares (ARCA:GLD) still remains one of the easiest ways to add the precious metal to a portfolio. The ETF is quite liquid and holds physical gold locked in a vault. Likewise, the PIMCO Enhanced Short Maturity Strategy ETF (ARCA:MINT) and Vanguard Short-Term Bond ETF (NYSE:BSV) represent cash and short-term bond plays. While returns for these funds may not be huge, safety concerns could trump the need for growth in upcoming months.

The Bottom Line
With various global macro-economic pressures facing the world's economies, it's no wonder hedge funds are braced for an uncertain fall. The flock to quality has once again been renewed. For regular retail investors, following their lead might not be such a bad idea.

At the time of writing, Aaron Levitt did not own any shares in any company mentioned in this article.

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