These predictions do not stand or fall by their accuracy, but by their appeal. Two peculiarities of human behaviour which can be everywhere observed, are that we expect the future to look the same as the past, and that we prefer bad news to good. The commentators are ever ready to feed our interest, even in good times, with forecasts of doom just around the corner, but when times are not so good, then they get really depressed.
So while markets are all but impossible to predict, market predictions are quite easy. They have a marked tendency to overshoot, especially on the downside.
Living in a different world
With this in mind, what can we say about the outlook for 2008? For financial markets, very little; for financial market predictions, they are likely to turn out to be too pessimistic.Currently the commentators are worried about the credit crunch, the US trade deficit (too large or too small), an assortment of people borrowing Japanese Yen, the price of oil, the price of real estate, and China, to name a few. All these factors are concerning in one way or another, but they are not new problems; we have seen them before, sometimes they have had serious consequences, at other times they have been overcome with little difficulty. But one thing is absolutely clear: the world is a very different place from the world of those previous encounters.
Even in the last few years there have been massive changes to the financial and even political landscape. On the whole these changes have been beneficial, while in excess they have perhaps contributed to the cracks in the financial system. But because the landscape is so different, predicting the effects of the current difficulties on hedge fund performance looks very difficult in all but a few areas.
What about asset growth? In recent years hedge funds have simultaneously benefited and been a part of the changes in the international financial system, both in capital flows and performance. But just what catalysed the growth is not clear to me: what exactly has changed over the last 10 years to cause such an improbably large shift of assets into hedge funds, and attract the attention of the world's regulators and taxmen, and even popular journalists? It is not the regulatory environment, the service providers, the fund structures, or the IT systems: these were all quite adequate 20 years ago (well, in some places, at least). It is mainly that the success of hedge funds has generated its own success.
"The world is a very different place from the world of those previous encounters"
2007 has been a volatile year for most traders. Within our own area, quantitative equity and futures trading, there were wild swings and market dislocations in the summer, such as had not been seen since 1998, at least. Although we have ourselves benefited from the unusual trading conditions, the quantitative equity industry has had significant outflows in the second half of the year, which has weighed on its performance, and may continue to do so next year (or, I have to add, may not).
However, there is obviously considerable value to be found in the wake of this year's turbulence, not least in the credit markets. There should be some excellent returns made by those investors brave and nimble enough to get into the funds best positioned in distressed debt (and there's a lot of it), although the modest scale of the losses to date suggest that it might be too early yet.
Bad year for beta2007 was a bad year for those funds with more beta(s) than alpha, and investors will be trying harder than usual in 2008 to find alpha rather than beta. Fortunately the high volatility looks set to continue for some time, which should be good for liquidity provision strategies such as statistical arbitrage and other short term trading funds. When markets return to more normal conditions, accompanied by lower volatility, the carry and macro funds should have a good period. It will be difficult for investors to time these factors: better look to the multistrategy funds, whose combination of investment ability and nimbleness in allocating capital will be invaluable in such a heterogeneous environment.
Investors talk transparency a lot but rarely seem to value it quite so much in practice. For the time being, however, hedge funds with simple, liquid portfolios and observable pricing are finding it easier to attract money than those with complex portfolios and obscure pricing.
Meanwhile the main driver of growth in our own areas, the development of electronic exchanges, is continuing to change, albeit slowly, the way the game is played just about everywhere, with perhaps the biggest impact coming in the huge foreign exchange markets.
The advantages of electronic exchanges are clear: increased liquidity and lower transaction costs, but the pace of change creates challenges for participants, who must overhaul their trading platforms and practices every year or so.
