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“Many funds of hedge funds (FOHFs) are still dealing with liquidity issues beyond the recovery in equity and credit markets,” said S&P Fund Services lead analyst Randal Goldsmith. “Underlying net market exposures within FOHFs are also below historical levels, but have increased during the third quarter. In general, net exposures have moved up only gradually because hedge fund managers held in FOHFs portfolios have not been convinced on the sustainability of the rally in markets and have preferred to concentrate on alpha generating opportunities.”

Goldsmith says this was particularly the case in Europe, where returns have generally been disappointing despite competitive returns in the underlying equity markets. Some FOHFs managers have also deliberately resisted increases in aggregate net exposure.

“GAM's David Smith maintains an agnostic view on markets and has focused GAM Diversity's portfolio on managers able to generate alpha regardless of market conditions," said Goldsmith.

Goldsmith also pointed to Charles Hovenden, CIO of Absolute Fund Managers, who deliberately reduced exposure to Crispin Odey’s hedge fund this year because the manager took net market exposure up to a higher level than he was comfortable with. “Hovenden tends to avoid equity hedge fund managers who run their portfolios with net exposures over 30%,” said Goldsmith. “On the other hand he has continued to hold a small exposure to short-biased managers despite disappointment with their slowness to cut losses on cyclical shorts.”

FOHFs returned 4% over the third quarter, and 8% over 2009 so far, with funds that focus on emerging markets leading the recovery. Among S&P Fund Services-rated FOHFs, GAM Multi-Emerging Markets has returned 20.5%, Permal Asian Holdings has returned 24.8% and Permal Emerging Markets Holdings has returned 26.1%.

One positive surprise has been Permal Japan Holdings, which has returned 16.0% over 2009 to the end of September. “Japan has been a laggard in the equity markets recovery, but Permal's team was relatively quick to go fully invested on this fund,” said Goldsmith. “Its selection of long-only managers – about 26% of the portfolio – has collectively achieved more than double the market average return. Going forward, Permal sees some of the best opportunities for alpha generation in Japan where its hedge fund managers are able to find many stocks on extremely low valuations.” Corporate website: Source

- FG