'Absolute return' funds make money through thick and thin

Friday 23rd November 2001

This week Tower Managed Funds hosted a teleconference at which the guest speaker was David Smith, London-based head of Global Asset Management's (GAM) Multi Manager group.

Mr Smith manages money for clients who want to invest in hedge funds and also works as a head-hunter for suitable hedge fund managers. GAM specialises in managed futures and options funds, which are a subset of hedge funds or absolute return funds, and offers one of its products in New Zealand, the Tower GAM Multi Trading Fund, which has been around since 1994.

People like Mr Smith are interesting to listen to because, unlike other fund managers, they do not have to talk up the market they invest in.

Most fund managers are "long only" in that they either trade or buy and hold assets like equities, bonds or property to take advantage of rising prices. When the market runs their way, they are vocal enthusiasts for it, but when the inevitable cyclical downswing occurs, they can only resort to saying that things will come right again, that it is a great time to buy cheaply, and that investors should remember that they are in the market for the long term.

Hedge fund managers do not have to explain away downturns because they use derivatives like futures and options to sell short when the market falls over, making money out of crashes, just as they can profit from market lifts by buying long.

Whether markets rise or fall, hedge funds can make money through derivatives. Hence the alternative name of absolute return funds. Accordingly the opinions of their managers are both more neutral and more aggressive on market outlook than long-only managers.

Hearing someone like Mr Smith, who is responsible for about $US7 billion worth of investments in hedge funds, is a refreshing opportunity and indeed a rare one in New Zealand, to find out what a global investment expert without vested interest in market performance has to say.

Mr Smith gave his views on the international outlook for bonds and equities. So far as these markets are concerned, he noted that the key phenomenon they have displayed in recent years is synchronisation driven by the US.

The American sharemarket's trend is quickly followed by other sharemarkets. Fixed- income investments around the world are similarly driven by decisions made on interest rate settings by the US Federal Reserve. Currencies respond in large measure to moves in the US dollar.

It is difficult, therefore, to diversify away from risk posed by the US economy. Investors can run but they can't hide from market trends emanating from the US.

For the US sharemarket, Mr Smith predicted a rally before the end of the year followed by a collapse in January 2002. He said that the rally would be liquidity driven, meaning that US mutual fund managers were sitting on big piles of cash that they would have to invest. Their buying before year-end would drive up share prices.

On the supply side, he claimed that most sellers were already out of the market, so prices would have to go up to persuade others to part with their stocks. However, this liquidity-driven surge was unstable because the fundamentals for US equities were still dismal.

Mr Smith thought the news for US companies would be even worse in the New Year. Thus the US market has an internal contradiction, with too much money chasing shares in companies that suffer from continuing deterioration in their prospects.

The result, according to Mr Smith, would be a false rally followed by renewed downtrend.

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