FOHF performance lagged single hedge funds in 2009 by a ratio of one to two based on industry-recognised hedge fund index providers. Broadly speaking, multi-manager FOHFs had a six to eight percentage point lag over single managers at the end of the third quarter of 2009, notes a new quarterly report by Fitch Ratings. One explanation for this is the higher level of cash held by FOHF managers. Due to the intrinsically less liquid nature of FOHFs (they are dependant on the liquidity schedules of their own underlying investments), they tend to carry more cash on their balance sheet than single hedge funds.

This asset/liability liquidity mismatch has made FOHFs less flexible to react to the positive upswing in the market since March 2009. FOHFs have historically always underperformed single hedge funds in absolute terms and exhibited a slower reaction to market turnarounds. As a result, high water mark thresholds have been slower to be regained by FOHFs. “Many FOHFs are still conservatively positioned,” notes the report. “They are still entrenched in some liquidity issues, thus cleansing portfolios of illiquid and sharply devalued positions or simply with gross/net market exposures significantly below historical averages.”

This year will likely prove to be more challenging for both hedge funds and FOHFs as the massive influx of liquidity from coordinated government and central bank actions comes to an end. Event driven (mergers) and distressed strategies still remain a liquidity play and not yet driven by fundamental factors. “The success of merger arbitrage will depend on liquidity on company balance sheets remaining at appreciable levels, on interest rates not rising too fast and on a renewed investment cycle,” notes Fitch. For equity hedge funds, an expansionary monetary policy around the world has insured risk-free short term interest rates, sustaining investors’ appetite for risky assets. An eventual contraction of liquidity facilities would suggest that equity hedge funds will have to shift back to a more difficult fundamentally-driven market and rely on bottom-up research in a universe shaped for stock pickers.

For hedge funds pursuing relative value strategies with a debt-focused universe, abundant liquidity and wide spreads led to abnormally positive returns last year. This year may not be so easy. “As mush as 2009 proved a natural driving force for credit as evidenced by negative levels of CDS/cash bases and spreads tightening, 2010 could see CDS/Cash bases progressively normalise,” notes the report. Morgan Stanley’s Credit Derivatives Insights reported in November 2009 that CDS/Cash spreads were turning positive in the US and Europe. The main determinant of the difference between CDS spread and cash spread is the level of credit risk. When credit risk is rising, demand for buying protection rises and the basis becomes more positive. When credit risk declining, the opposite occurs. “While there is still room for a liquidity-driven rally, recent indications of more moderate and discriminating appetite of investors for primary issuance should remind the market that fair spreads are not so far away and the desperate rush for yields may come to an end,” concludes Fitch.