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Hedge fund forecast

Market prediction? Economists and strategists are bullish so start to get short. It's worth noting that equity markets are due for a major correction while the credit markets are way overdue for bearish conditions. Good or bad year for equity or credit beta, there are CERTAIN to be lots of market inefficiencies, mispricings and volatility to exploit for alpha. Do you really thing someone able to analyze securities or predict markets would be working on the sell-side?

Experts are mostly forecasting double-digit stock market returns so investors don't need to bother with "expensive" hedge funds, right? WRONG. Ignore cheerleader analysts! They underperform a broken clock in their forecasting accuracy. Investors with real money on the line don't know what any market will do so strategy diversification through substantial allocations to MANY hedge funds is the way to consistent portfolio performance. Good hedge funds are designed for investors whatever happens and to preserve capital and smooth the volatility of total portfolio returns.

Risk, like beauty, is in the eye of the beholder. I recently spent several weeks due diligence looking at prospective investments in Eastern Europe and Central Asia. I am pleased so far with the performance of my Romania, Bulgaria, Serbia, Ukraine, Armenia, Uzbekistan, Iran and Kazakhstan holdings. I would have made more being long only but establishing a partial hedge on frontier markets like them avoids major negative scenarios, especially with the illiquidity. We have already had a reminder from Thailand that emerging market debt and equity are sources of security selection NOT for long only benchmark hugging.

Hedge funds delivered on their promises for last year despite those who said the space was "past its prime", "too crowded" or "under threat". While hedge funds, as a group, did indeed "underperform" most stock indices in 2006, adjusting for risk, good hedge funds outperformed ALL stock markets. Proper hedge funds are not aiming to outperform an index, they are into generating RELIABLE absolute returns. Hedge funds "outperformed" by a mile in 2000, 2001, 2002 and that is why EVERY investor, institutional AND retail, needs a MAJOR allocation to hedge funds.

I predicted a big hedge fund would blow-up last year and, surprisingly, we got all the way through to September until the Amaranth meltdown. Wonder which "hedge funds" will blow this year? I absolutely believe in the value of good hedge funds to a portfolio but there are still plenty of idiots in the industry, some trying to "manage" multibillion AUMs. I also think we are overdue for an investment bank to get itself into trouble. Last year we saw some hedge funds shut down while some unskilled funds rode beta all the way. Maybe 2007 will permit less confusion between brains and a bull market in equity AND credit. Asset size and gathering power have NEVER been an indicator of competence.

Last year investors could have doubled their money in Peru, Namibia, Venezuela, China and Vietnam equities so why do people bother investing in "underperforming" USA, Japan and Western European markets? Government bonds are "risk free" apparently, so why waste portfolio space on JGBs and US treasuries when Ecuador's bonds might pay you a much higher yield? Perhaps because liquid, longer established bond markets are less risky. REAL hedge funds are safer too, since they hedge exposures and manage risk. Investors need the ENTIRE risk continuum of assets AND strategies in their portfolios, so they have plenty of zigs when other things zag.

Hedge funds, as a group, made double-digit returns last year. But there was clearly plenty of embedded beta as an assist for many funds. 2006 was the best year for hedge funds since 2003, which were ALSO the best recent years for the stock markets. What an amazing coincidence! Directional strategies like credit, distressed debt and emerging markets, in particular, benefited from very strong underlying bull markets. Most China-focused hedge funds made "high" absolute returns, but considering their heavy long bias, many were actually NEGATIVE alpha producers. If you believe the China growth story just buy FXI or similar. Hedge funds should hedge. Long only and long biased funds are for people who are bullish. Not conservative, risk averse people like me.

Meanwhile in Japan, big cap equities did nothing while small caps fell apart which provided a great chance to identify which Japanese fundamental equity funds were hedge funds and which were not. Skilled hedge funds prove their worth in BAD conditions for their strategy. Energy was a tough market for many, fatal for Amaranth Advisors and others, while funds like John Arnold's Centaurus Energy and Boone Pickens' BP Capital Management demonstrated their energy trading skill by MAKING money in a bear market for the securities in which they operate. Inevitably, convertible bond arbitrage did well after a nice shake out and numerous "death of CB arb" predictions from the "experts".

2007 could be better than 2006 OR maybe it will be worse for long only than 2002. If it turns out to be a solid up year for equities, some investors might regret they had money tied up in hedge funds but if it is a bad year for the markets, they will be glad they made a commitment to superior, safer ways of managing money. As for predictions, I was reasonably accurate with last year's market forecasts and reiterate them.

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