Hedge Funds May Miss Out on Rally by Reducing Equity Risk

BOSTON (TheStreet) -- Hedge fund managers are facing a trial by fire between now and the end of the year. With many funds down this year, some will be out of a job come January.

These investment golden boys are being tugged in different directions. For one thing, they're as fearful of incurring more losses in this year's unpredictable market as the average investor is. As a result, many are in a cash-heavy, defensive mode.

That means they wouldn't be ready to take full advantage of a fast-moving stock-market rally, even though many market strategists are anticipating one. For example, Oppenheimer & Co. last week reiterated its 2011 S&P 500 Index target of 1,325 by year-end, a 10.8% premium to the benchmark index's current level. Other Wall Street firm's market strategists are equally bullish.

For now, fund managers are awaiting early third-quarter earnings to see how they stack up against expectations before getting back into the market in a big way. In particular, they're eager to see companies' guidance for next year.

What's worse, there's the possibility that a fourth-quarter rally has already started. In the five days through Oct. 11, shares in the S&P 500 rose 3.4%, the biggest five-day gain since the market's March 2009 bottom.

Hedge funds, which manage money on behalf of wealthy investors and institutions such as pension funds, are looking at a losing year if there isn't a big rebound. On average, they fell 4.2% in September, bringing losses for the year at the end of the third quarter to 7.8%, according to the Dow Jones Credit Suisse Hedge Fund Index. The benchmark S&P 500 Index, in comparison, declined 14.3% through the end of the third quarter, with half that coming in September.

Fund managers' indecisiveness, in part, is due to the host of economic uncertainties facing investors, ranging from the sovereign debt crisis in Europe to the economic malaise at home, as well as the possibility that many of their clients will ask to cash out of their positions after a losing year.

The result is "abnormally high cash levels and low net exposures" to stocks and other investments, said Charles Gradante of the Hennessee Group, a hedge fund advisory firm.

"Managers are looking for market transparency and stabilization before getting reinvested," he said. "Consequently, their reactive cash and net exposures present relative 'whiplash' performance risk should there be a sharp equity rally in the fourth quarter."

And yet those same managers "say they wouldn't be surprised by a fourth-quarter rally," Gradante told TheStreet.

"It's almost bipolar," he said of their market stance. "We've had a rally this month and taken back more than half of what (was lost in September), but yet you look at the portfolio of the long-short equity guys and they are anywhere from 0% to 40% net long (representative of their equities stake) with an average of about 20% net long."

Another challenge for the managers is that many hedge fund investors, disappointed by their fund's performance, will send notice that that they intend to redeem their stake at year-end, which is forcing fund managers to start setting aside cash for that now.

But if there is a rally, that money would be on the sidelines and not be working for its keep. Ironically, many of those same clients could then decide to cancel their redemption notice on seeing a market rebound, adding to hedge fund managers' frustrations.

Gradante noted that a quarterly performance for a stock portfolio can be determined in only four or five days of market performance for the whole period, which can happen in as unpredictable a market as the current one.

So if a fund were to miss out on a one-day 5% gain due to a manager's indecision or lack of cash, that could hurt a fund's performance in comparison to its peers for the whole quarter, which means managers need to stave off their fears and take on more risk.

But their conservative stance also means that most hedge funds can meet their investors' requests if, indeed, the market turns against them. Gradante said that long-short equity funds with an average of 20% cash are well-positioned to meet redemptions and still have cash to invest in a rally.

It's those with only 5% or 10% that could get squeezed, he said.

Net assets of hedge funds, at just under $2 trillion, are flat to the start of the year, he said. That statistic is influenced by investor fund flows as well as investment performance.

For the year through the end of August, the latest period that data was available, hedge funds saw inflows of $51 billion, about on par to the $52 billion they saw for all of 2010, according to TrimTabs.

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Disclosure: TheStreet's editorial policy prohibits staff editors and reporters from holding positions in any individual stocks.

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