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Sun 2 Mar 2008 04:00 AM

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Hedge funds look to profit from volatility

Global markets have been characterised by low volatility over the past four years as equities recovered strongly from the post September 11 sell-off and the collapse of the tech-bubble in 2000. Cheap credit flooded the market, creating excess liquidity. That created an environment where it was difficult for hedge funds to stand out or for skill-based investment to outperform the broad market.

Global markets have been characterised by low volatility over the past four years as equities recovered strongly from the post September 11 sell-off and the collapse of the tech-bubble in 2000. Cheap credit flooded the market, creating excess liquidity. That created an environment where it was difficult for hedge funds to stand out or for skill-based investment to outperform the broad market.

That changed dramatically last August, as the credit crunch led to forced disposals of large quantities of lower quality debt and created some market uncertainty that has not been seen since 2002. As a result, credit prices have strayed from fair value offering ample opportunities for investors with strong balance sheets.

The repricing of the credit markets will create opportunities in distressed securities.

Volatility is likely to remain at a heightened level as long as economic uncertainty remains and mixed sentiment combine to create a wider range of pricing inefficiencies for hedge funds to profit from.

This is generally positive for most hedge fund strategies over the short term, though further market corrections could still inflict pain on leveraged positions. Stocks appear to be relatively cheap at present, and offer excellent upside potential if credit concerns turn out to be overdone. That outlook could worsen sharply, however, if the US enters into a recession.

There is also likely to be greater dispersion between equities as investors focus on corporate balance sheets and growth potential rather than buying the broad market. That will favour stock pickers. The current market anxiety should be a catalyst for higher volatility too, creating more opportunities for hedge funds.

With the potential for strong gains, investors who sit on the sidelines could miss a good buying opportunity. However, if the US housing market sours further or consumer spending falls dramatically, investors who pile in could take a hit. In this environment, equity hedged strategies will benefit from increased volatility.

Event-driven managers have been among the best performers in recent years, helped by a boom in mergers and acquisitions. That boom ended abruptly in August, as the easy credit that fuelled it, dried up. While venture capital firms still have plenty of cash to put to work, it seems likely that deal flow will slow in the coming months.

The repricing of the credit markets will create opportunities in distressed securities, so the style should continue to offer upside potential. The slowdown in deal flow means gains from event-driven funds may narrow somewhat.

There is a wide range of possibilities for macro managers to exploit. Mispricing in credit markets, a weak dollar, concerns over oil supplies, mixed growth in Asia, soaring wheat prices, political uncertainty in Russia (with possible implications on gas supplies), and a number of other issues means that managers should be spoiled for trading opportunities over the next year.

Increased volatility and credit repricing should benefit relative value and arbitrage managers, particularly credit arbitrage where hedge funds will be able to distinguish themselves through superior credit selection, fixed income arbitrage and volatility arbitrage.

Convertible bond arbitrage could struggle if equity prices fall as this may trigger a sell-off. Over the longer term, this correction in credit markets marks the end, or at least the beginning of the end, of the extended period of easy liquidity we have seen in recent years.

That liquidity drove the reflation of equity markets and was a catalyst for low volatility, which hampered hedge fund strategies and blurred the distinction between skill-based and passive investment approaches. In an age of greater volatility, it is likely that the balance will swing back to skill-based investing.

Antoine Massad is the CEO of Man Investments Middle East.

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