Hedge funds dig deep for greater returns

When the latest intake of hedge fund analysts arrived for their first day of work they might have imagined a life of poring over spreadsheets, and routine research trips to shiny corporate headquarters.

More recently, however, they might instead be expected to scope out an egg factory in a remote war zone, or eye up the quality of the brick work on an office block in the north of England.

Faced with meagre returns on bonds and highly valued stocks, an increasing number of hedge fund managers are seeking out more adventurous opportunities in order to deliver the type of high returns investors expect from the industry.

"Hedge fund managers are looking at more esoteric investments when they are looking for yield," says Russell Barlow, head of hedge funds at Aberdeen Asset Management. "Yields have come in across the board, and as yields continue to compress across the more mainstream asset classes some managers are choosing to look further afield."

Many hedge funds that specialise in credit have reached a point in the market cycle where most of their successful trades have become crowded and difficult to navigate. Over the past year investors in these hedge funds say they have become more used to managers pitching them ideas that would previously have been seen as edgy for even the most risk-tolerant.

An investor describes a pitch by one hedge fund to provide working capital loans to food exporters in Ukraine, such as egg factories, where double digit returns were promised for tying up money for 60 to 90 days.

"These sorts of trades usually involve only a small amount of exposure, but you need to take on war risk and political risk to get it done," the investor says. "These funds are not specialists in this sort of thing, but in a world where spreads are at all-time lows they are just trying to find returns."

Another group of hedge funds, according to their lawyer, who wanted to remain anonymous, last year explored the idea of buying up the euro-denominated Cypriot bank accounts of Russian citizens who had been placed under sanctions. By offering a so-called haircut to the holders, they hoped to make a quick return once the situation normalised, but the scheme was eventually scuppered by compliance fears, the lawyer said.

Investors say that while hedge fund managers argue that they only seek to take on small pockets of risk that they understand, most are reluctant to be seen in public to be dabbling in the darker corners of the international markets.

The shadow of the pre-2008 world of hedge funds betting on highly illiquid holdings only to lose large amounts of money during the crisis still hangs over the industry.

At the same time, some of their investors, many of whom are large institutions such as pension funds, are more willing to accept risker propositions at a time when they are starved of returns elsewhere.

"Some hedge funds are going out to less liquid instruments, but they also have their investors pushing them that way," says Mr Barlow of Aberdeen. "We are reluctant to be taking that same path, unless we have a structure and a mandate to do this. The risk is investors are just focusing yield and may not be focusing on things like liquidity risk."

Other hedge fund managers have focused their efforts on the more humdrum world of peer to peer and secured property lending. Omni Partners, a London-based hedge fund, has recently raised $45m of a planned $250m fund which makes short-term loans predominantly to developers across the UK secured against their properties.

Steve Clark, Omni Partners' founder, argues that the 10.4 per cent net return delivered by the first incarnation of the fund last year demonstrates it is possible to generate double-digit performance through alternative lending without taking on large risks.

"There's continued demand from investors for an unlevered high yield strategy that has the key characteristics of superior asset quality and short tenor," he says.

Yet for the hedge funds that are trying to navigate a world of meagre yields, there are others who have decided that the best strategy for a market they view as overvalued is to bet against it.

Crispin Odey, in this case an investor focused on stocks rather than credit, recently became one of the first well known hedge funds to position for a big fall in the stock market, based in part on his belief that the end of quantitative easing in the US could trigger large and unintended consequences across global markets.

One part of this strategy has been to use the shares of asset managers as a proxy for betting on a sell-off in emerging markets, as well as taking out numerous other so-called short positions against unprofitable companies he thinks investors have tolerated only due to low interest rates.

Other equities-focused hedge funds have eschewed the larger macro economic call of Odey, and instead continued to look for individual opportunities to make money through short selling.

Kyle Bass, founder of Dallas-based Hayman Capital Management, earlier this year said he would bet against pharmaceuticals companies while at the same time mounting legal challenges against drug patents he believed were unenforceable.

Managers such as these will need to have strong stomachs to withstand the long periods of paper losses that contrarians must endure, and for now it appears only a few feel bold enough to make outright bets against the status quo. For the rest, if interest rates continue to remain low they may need to get increasingly accustomed to trips to war zones to make money.

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