Hedge funds battle to show their worth in emerging markets sell-off

By Simon Jessop

LONDON/PARIS (Reuters) - A sell-off in emerging markets has given hedge funds a chance to prove they can profit from even the most testing market conditions - and try to justify their lucrative fees.

These are conditions in which hedge funds are meant to be able to outperform, using their much wider array of trading tactics to capitalise on default risks, currency routs and share price falls.

After underperforming regular stock benchmarks for the past five years, this year they have just about managed to beat the market, according to Hedge Fund Research's HFRX index, gaining 0.9 percent this year to February 25 compared with a 4.7 percent fall in the MSCI Emerging Markets index and a 0.3 percent gain in the S&P 500 Total Return index.

Even so, some are struggling, as shown by Brevan Howard's decision to shut its $2.3 billion emerging markets fund.

Analysis by asset manager BlackRock of last year's hedge fund performance underlines the wide divergence in performance. http://link.reuters.com/hab37v

An investor who chose the most successful hedge fund strategy last year - equity hedge, for example - could have seen outperformance, or alpha, of around 20 percent in the best performing funds or minus 15 percent in the worst.

Even the top funds would have lagged a pound, dollar or euro invested in a major index such as the Standard & Poor's 500, up 30 percent.

But pension funds and others with a lower risk threshold also use hedge funds because their greater tactical scope adds to the options for achieving less volatile, and in some cases more profitable returns than just tracking the market.

"Last year, you could just buy beta (track the market) in both equities and credit, and sell gold and Bunds. This year ... it's much more complicated," Philippe Ferreira, head of research, alternative investments, at Lyxor AM.

"In this context, investing in hedge funds is a good way to get protection and de-correlation with the market, and in that sense hedge fund performance in January showed they did just that: strategies with less directionality producing positive results while stock indexes fell."

In fund management overall, market-tracking "passive" strategies are expected to grab market share from "active" strategies by 2020, a recent study from consultants PwC found. But assets under management in alternative investments, which include hedge funds, will more than double to $13 trillion, PwC said.

The wide spread of absolute returns found in the BlackRock analysis is even more marked when comparing the amount of outperformance generated by the funds.

Using the example of last year's top returning strategy, equity hedge, for example, the study found the average fund actually detracted from the performance, while strategies such as event-driven added nearly 4 percent of alpha.

"The dispersion shows the average hedge fund return is very different from what's available in the hedge fund universe," said Mark Woolley, hedge fund analyst at BlackRock, adding that "the greatest return does not necessarily mean the greatest amount of alpha".

GRIND HIGHER

A bounce off January lows has given way to a slow grind higher on many global stock markets with increased volatility.

That pattern is expected to persist as the U.S. central bank cuts back on its cheap funding injections, China moves to tighten up on risky lending, and emerging market weakness weighs on recovery prospects in developed economies.

Winners so far this year, according to the HFRX index, include Cumulus Energy fund, up 21.9 percent to February 14, and Horseman Global, which had gained 9.4 percent to February 19, according to data seen by Reuters.

But Brevan's Emerging Markets fund fell 15 percent last year and a further 1.6 percent in January, while its Emerging Markets Local Fixed Income fund is down 0.2 percent.

BlueCrest's Emerging Markets fund is down 0.2 percent so far this year, while U.S.-based Contrarian Capital's Emerging Markets fund fell 6.2 percent in January but made back most of those losses this month.

With so many political and economic troubles undermining the road to high returns in emerging markets, choosing a successful fund is not getting any easier.

"We think the difference between good and bad emerging market economies is going to get more pronounced, which will make it trickier to perform," said Odi Lahav, CEO at Allenbridge Investment Solutions.

(Clarifies in paragraph 6 that the figures refer to alpha, not absolute performance.)

(Editing by Ruth Pitchford)