It is a struggle to make money in the hedge fund world - a struggle that has lasted for the last year and a half. Hedge funds as a whole racked up a miserly 4 per cent return last year, and half way through this year are on track to do little better.

Some people are starting to suggest that the answer to the problem is some hedge fund research and development: the funds need to find a new strategy.

Strategy after strategy - from merger arbitrage, convertible arbitrage, long/short equity investing and statistical arbitrage - are all suffering in this lacklustre, sideways-moving market. Aside from distressed bonds and emerging markets, there is very little to get excited about in the hedge fund world.

"Everybody is looking for alpha," observed Gil Caffray, partner at Frontpoint Partners, a Connecticut-based hedge fund firm, referring to managers' efforts to outperform their markets. Growing efficiency in those markets has also reduced arbitrage opportunities, he added.

Meanwhile, the hedge fund industry continues to grow at anear-record pace.The Hennessee Hedge Fund Advisory group put growth - from both capital appreciation and inflows - at $140bn last year. TASS Research, which also monitors inflows, put figures lower, and falling slightly in the first quarter. Still, both data sets show the industry growing at a nearly record pace.

One of the biggest issues caused by that growth is capacity. Merger arbitrage funds are swamped with money because there are too few deals for them to invest in. Convertible arbitrage funds risk becoming similarly swamped as new convertible issuance slows.

But there is a broader issue of a lack of opportunity in the market. Even with leveraged hedge funds making up a small proportion of the $30,000bn global equity market, investors are struggling to make money.

Hedge funds are constantly seeking new opportunities. Two big, multi-strategy funds, Tudor Investment and Citadel Investment Group, recently hired people to boost their power trading efforts. The theory is that the retreat of the big power companies has made trained personnel more available, while opening up a large, highly technical market.

Hedge funds are constantly seeking new opportunities. Two big, multi-strategy funds, Tudor Investment and Citadel Investment Group, recently hired people to boost their power trading efforts. The theory is that the retreat of the big power companies has made trained personnel more available, while opening up a large, highly technical market. The question hanging over that market is the extent of its liquidity after Reliant Resources, CMS and Dynegy admitted to entering into "round trip" deals that exaggerated their revenues and the size of the market as a whole.

There are a handful of successfully institutionalised, multi-billion dollar funds, including Citadel and Tudor, that could become hotbeds of hedge fund innovation. They are seeking new products because they aim to provide strong returns across different business cycles. So far, however, they have merely expanded into existing strategies rather than developing new ones.

Some investors think that may be enough. "I tend to think that the hedge fund world is the harbinger of change in the financial world," says James Hedges, manager of LJH Global Investments, a fund of hedge funds. "It is far more diverse than it was 20 years ago."

Firms like Julian Robertson's Tiger Management pioneered international equity investment, Mr Hedges says. More recently, hedge funds evolved distressed investing as a new strategy and after that helped build the emerging markets business. Mr Hedges says hedge funds are now expanding into the under-exploited markets of Europe and specialising in narrower equity sectors.

But others question whether that is sufficient. One solution to the lack of hedge fund innovation, according to Gabriel Burstein, head of relative value sales and research at HSBC's equity derivatives group, is to develop new hedge fund strategies.

Hedge funds' edge over traditional money managers has always been their ability to use finance's basic building blocks, such as stocks and bonds, in an imaginative way. Traditional managers simply buy and hold equities, Dr Burstein explains, while hedge fund managers use equities in merger arbitrage, statistical arbitrage, convertible arbitrage and long/short equity. Similarly, hedge fund managers use bonds and derivatives in bewildering combinations that traditional managers would probably never attempt.

Mr Burstein has developed a strategy called macro-economic arbitrage that he thinks could go some way to filling the gap. Global macro-economic funds tend to take directional risk, unlike arbitrage funds, which take advantage of temporary pricing dislocations. Mr Burstein sees ample opportunities in the non-directional trading of assets, which are hit by the same macro-economic stimuli.

For example, an investor might take the view that German banks should trade relative to German insurers based on domestic interest rates. Then, if that relationship changes, the investor sells the insurers and buy the banks.

There is other evidence of hedge funds thinking out of the box. Framework Investment Group, a newly launched New York-based firm headed by Andrew Gitlin, a veteran hedge fund incubator, says it is taking a new approach by trading commodities in both the physical and cash markets. Framework can take delivery and store commodities in warehouses around the world. This is useful because financial buyers, who cannot take delivery of a commodity, often duck out of commodities market just before settlement, creating a short-term pricing discount.

The hedge fund world seems evenly split between those who think there is nothing new under the sun and those who believe hedge funds are constantly developing new ideas. Nobody denies, however, that returns are tight and that some creative thinking might be necessary to boost them.

This article appeared in the Financial Times on June 27 2002.

© Copyright Financial Times 2002.

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