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Hedge funds are crawling back to life after a turbulent 2008 that has almost halved their assets, and fewer but stronger survivors are set to regain their leverage to chase bargains in a less competitive environment.

Hedge funds, which manage their portfolios aggressively with various advanced strategies including derivatives to gain higher returns, suffered double-digit losses last year after global stocks and commodities tumbled because of the credit crisis.

As a result of client redemptions, the amount of investor capital managed by single-manager hedge funds might have halved to close to $1 trillion by mid-2009 from the 2008 peak of $2 trillion, according to the European Central Bank.

But the pace of withdrawals is slowing down. There are also signs that the level of leverage has bottomed out.

The return profile is improving. After a 19 percent loss in 2008, hedge funds have returned 6.7 percent so far this year, with the bulk of gains coming in the second quarter, according to the Credit Suisse-Tremont Hedge Fund index.

This compares with an 8 percent gain on the benchmark MSCI world equity index since January.

“The key thing is the lack of competition – bank proprietary desks have stopped trading and hedge funds have taken the leverage right down. So there is less capital chasing after value,” said David Miller, partner and head of alternative investments at Cheviot Asset Management.

“We have an easier competitive environment. Particularly in the UK we’ve been interested in listed hedge funds. We’ve got substantial discount to net asset value. You can buy in cheap prices.”

LEVERAGE RECOVERY

Leverage – bread and butter of hedge funds – is showing signs of stabilization.

According to a survey from Banc of America Securities-Merrill Lynch, the weighted leverage of hedge funds – ratio of gross assets to capital – increased to 1.03 in June from 0.82 in December.

In August 2006, the weighted leverage was as high as around 2.4.

“The reduced availability of leverage raised questions regarding the viability of leverage-dependent investment strategies,” the ECB said in its bi-annual report.

“However, despite the significant tightening of margin terms since the start of the turmoil, the haircuts set by banks for good investments were still rather reasonable, i.e. leverage was still available,” it said, adding that only prime broker banks became very selective with respect to the securities they accepted as collateral.

Banc of America-Merrill Lynch’s data also showed hedge fund net exposure rose to 35 percent this month from 25 percent in May, having maintained limited involvement in markets up to April.

According to Hedge Fund Research, hedge fund liquidations fell by 50 percent in the first quarter from the record levels set in the previous three months, with 376 funds closing in the period compared to 778 in the fourth quarter.

STRATEGIES

As the return profile improves, funds are likely to see less outflows and may attract new capital looking to gain higher returns.

Convertible arbitrage – one of the worst performing hedge fund strategies in 2008 with a loss of more than 30 percent – has rebounded strongly with a gain of 10.6 percent this year.

This strategy aims to profit from the purchase of convertible securities and subsequent shorting of the corresponding stock.

“Opportunities for adding alpha are coming back. Fewer hedge funds and fewer players are trying to arbitrage the opportunity. There is less competition,” said Emiel van den Heiligenberg, head of asset allocation at Fortis Investments, which has exposure to hedge funds.

Two poorest performing strategies this year are dedicated short bias and managed futures, which are down 9 percent and 5 percent respectively, after coming ahead of others in 2008.

Swedish bank SEB likes equity long/short funds as they are easy to understand, have functioning risk management systems and low gearing, and offer built-in protection to equity exposure.

It also likes fixed income strategies as they invest in investment grade and high yield corporate bonds. The bank is neutral on distressed, event driven and macro strategies.

“Hedge funds that are already strong will have an opportunity to further strengthen their position, and the investment opportunities appear attractive,” SEB said in a note to clients.

“This is because there is less competition for good ideas than a year ago, when the hedge fund asset class as a whole was nearly twice as large, and trading by major banks for their own account has decreased significantly.”