Event-Driven Hedge Funds Dominate Inflows and Performance

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The phrase “A rising tide lifts all boats” is frequently used around Wall Street when the good times roll. It basically helps to explain why in a good market almost everything works, with little regard for who is running the show or holding the assets. In the world of hedge funds, this has been a very solid year for not only capital inflows, but from a performance standpoint. In fact, according to HFR, capital inflows for the first half of 2013 exceeded the first half of 2012 by 50%. The rising tide of the equity markets has helped many of the top funds. The one sector in the hedge fund world that has been a dominant winner is the event-driven (ED) strategy.

This hedge fund category has been so successful it has dominated the top three spots for hedge fund success and gains this year. The top category year to date according to Credit Suisse Prime Services Risk Advisory department is event-driven distressed. This category is up almost 9% year to date, and typically the managers focus on distressed debt, but they also can use distressed equity as well. Good examples of possible trades could be a fund manager buying the debt and equity of drugstore chain Rite Aid Corp. (NYSE: RAD). The stock closed at $1.40 on the first trading day of this year, and it closed Friday at $4.70. The debt has rallied in a commensurate fashion. Expected to be on the verge of bankruptcy less than a year ago, the company stunned the street with a huge earnings surprise two weeks ago.

The number two category for success is the very broad event-driven strategy. This strategy was up 8.6% through August of this year. ED funds strictly look for any item that can move the market up and down. Many have computer programs that constantly scan world headlines looking for even five seconds of lead time. A perfect example was on Friday, September 6. Despite a less than stellar jobs number, the market opened up much higher. Within 15 minutes, headlines said Russian president Vladimir Putin would help the Syrian government if strikes launched against it. Immediately the market dropped more than 140 points on the headlines. If a fund quickly has that data and can short the S&P 500 seconds in front of the news, it can make big money. Often event-driven hedge funds are focused more big picture, like the ongoing Syrian situation and companies that may do business there or in the region.

Coming in number three is event-driven multi-strategy. This category was up 8.5% through August. In this situation, the portfolio manager has wide discretion on what kind of direction to take. It can be long or short stocks, bonds, currencies, commodities and just about any asset category that can be affected by a specific situation. The manager also can reach into the distressed category that can be everything from debt trading at pennies on the dollar to stocks trading in the penny stock range.

One trade that some managers put on was as a result of an ED situation that took years to play out and pay off. Many hedge fund managers dug through the rubble of what was left of Lehman Brothers after it filed for bankruptcy and bought huge chunks of the debt. Obviously no one was to be made whole on the bonds, but certain managers, like Kyle Bass from Hayman Advisors, were shrewd enough to figure that when the existing Lehman assets were divided up, the recoveries from the Lehman estate could be in the $55 billion to $60 billion range. With much of the debt trading at literally pennies on the dollar, a large position could yield some fantastic gains.

No one can be sure what category will dominate the hedge fund world next year. One can be pretty sure that hedge fund managers are shorting U.S. Treasury debt. The fact that rates cannot stay low forever was not lost on all the funds that had leveraged carry trades in the spring. The minute that Federal Reserve Chairman Ben Bernanke even suggested the tapering of the current quantitative easing (QE), they decided it was time to get out while the getting was good. As a result, yields spiked 100 basis points, or 1%, in almost record time.

Also, many fund managers may be taking advantage of the huge slump in gold prices this year. The sheer fact that so much money creation has taken place, not only in the United States but around the globe, may be a harbinger of inflation to come. In fact, that is exactly what the people running the central banks are trying to achieve. They want to “reinflate” their economies. So by definition, it should come to pass. Maybe not this year or next, but sometime in the future.

One thing is for sure, hedge fund managers will not be seen on CNBC giving away all of their trades. They like to remain as secretive as possible, especially if they feel they are on to a trade that isn’t crowded. Typically by the time their positions show up in filings, they have been on for a while. Unless they are activist managers, who want to air their case, they avoid too much publicity. As we have pointed out recently, activist fund managers are having a serious impact on Wall Street.