Strong Asset Growth, Lower Returns

In the past few years the hedge fund market has grown in a spectacular manner, with total assets surpassing US$1 trillion in the first half of 2005. This growth has been aided by the lacklustre returns on the equity markets since the burst of the dotcom bubble in 2000 and by a benign climate for many hedge fund strategies, resulting in double digit annual returns for many hedge funds. However, with the strong increase in hedge fund assets, in combination with a changed market environment, it has become more difficult to make the same returns in many hedge fund strategies. In relative value arbitrage strategies in particular, more money seems to be chasing a smaller set of opportunities, resulting in lower or even negative returns.

Given this background we feel that strategy allocation is the main issue for investors in hedge funds over the next 12 to 18 months. Clear thinking will be needed to avoid trouble spots and to profit from the opportunities that will ensure that hedge funds remain an attractive asset class. We are in a world of tight spreads, not just for credits but also merger arbitrage spreads and liquidity-related spreads. It is an environment of flat yield curves, slowing growth and rising interest rates. On the other side we see a world of asymmetries: Chinese growth versus the rest of the world; Japanese consumer savings versus US consumer profligacy; US imports greatly exceeding exports. A world of falling liquidity and increased risk. In short, an environment in which it will be harder for hedge fund managers to make money.

Strategy Allocation Going Into 2006

Our response to this environment has been to revisit our allocation to hedge fund strategies and to question the rationale for some strategies. We see the risk/reward trade-off in the arbitrage strategies in the "relative value" area to be particularly unfavourable. Many of these arbitrage strategies suffer from excess capital and a lack of opportunities. We believe that the problems in convertible arbitrage and credit arbitrage strategies will persist for some time. The risks in fixed income arbitrage look high, given falling liquidity, flat yield curves and tight credit spreads. Traditional merger arbitrage, in addition, still looks to be a dead strategy with too much capital immediately available from either investment banks or hedge funds, whenever a deal is announced. The tight spreads have persisted despite the increase in deals in the last year.

The broad area of asset-backed securities within credit driven strategies is a relatively new phenomenon. There continues to be innovation in the credit markets and a proliferation of structured products, mostly in collateralised debt obligation (CDO)-type structures. This has led to innovative hedge fund strategies in which the managers trade in the various tranches of CDOs. But these are inherently illiquid strategies that have not been tested yet in a crisis period.

Macro Strategies
So, going into 2006, which strategies have a more promising outlook? First of all we see a good outlook for macro strategies. Continuing imbalances and asymmetries globally lead to opportunities for macro managers. We have favoured managers who benefit from rising volatilities and the emergence of trends out of these situations. Macro managers are less affected by falls in liquidity and have the most chance of profiting from any severe disruptions in credit or equity markets.

Asian Opportunities
Asian strategies have been another positive theme for us. We are attracted to the differential growth prospects and the low allocations to hedge funds investing in Asia. We see opportunities across several strategies and countries in the region. We have been enthusiastic about Asian distressed debt strategies for quite a while and see interesting opportunities for "activist investor" hedge funds in the region.

Event Driven Equity
A final area of potential has been in the rather ill-defined category of Event Driven Equity trading. Corporates have built up substantial cash on their balance sheets and restructured their debt. Many are now using these balances to buy back shares, take over other companies, make large capital investments or engineer leveraged buy-outs. The weight of money in buy-out funds is impacting equities with asset backing or unleveraged balance sheets. Hedge fund managers who are able to trade around these corporate events look to have abundant opportunities.

How Can Investors Take Advantage of These Opportunities?

Hedge fund research is labour intensive and it requires a lot of skill and resources. The complexity, lack of transparency and poor liquidity of most hedge funds make it harder to predict which funds will provide returns and which funds will not. Many institutions have therefore opted to get exposure to alternative investments via funds of hedge funds. Funds of hedge funds will perform the required due diligence of underlying hedge funds, add diversification and will try to outperform the general hedge fund index through the construction of their specific portfolio of hedge funds. As compensation for their activities they will typically charge a management fee and a performance fee of up to 20%. We have recently seen some downward price pressure on the fees charged by funds of hedge funds. This can be seen as a sign that the industry is maturing and also as a consequence of the more difficult environment for hedge funds and funds of hedge funds. In an environment with lower average gross returns many investors will focus more on the level of management and performance fees.

Innovations in Fee Structures for Funds of Hedge Funds

One of the more interesting responses to this development is the advance of "in-house" funds of hedge funds. An "in-house" fund of hedge funds will invest exclusively in hedge funds that are managed by or affiliated to the fund manager's own company. This stands in contrast to the traditional approach of funds of hedge funds where the complete accessible hedge fund universe is researched to identify best-of-breed hedge funds. To compensate for this, "in-house" funds of hedge funds will typically charge very low or no management and performance fees. Hedge fund managers that have adopted this trend include Gartmore, the MAN Group, Barclays Global Investors and ABN AMRO Asset Management.

Cost-effective Hedge Fund Access

This type of fund of hedge funds has several advantages for institutional investors. It provides cost-effective access to a limited, but diversified group of hedge funds. The management company also ensures an institutional type of oversight on risk management and operational processes. By construction, the fund of funds manager has full access to position and risk data and has therefore a precise take on the risk exposures in the fund of funds. These funds of funds can also deliver interesting performance propositions. The chart of ABN AMRO Asset Management's in-house product shows that these funds are able to deliver attractive performance with reasonable volatility. This makes these funds a useful tool for institutions as one of their funds of hedge funds in their alternatives portfolio or as building block in a single hedge fund portfolio.

Important Information
This material should not be distributed to private customers, as defined by the FSA, in the UK. Nothing in this material should be construed as investment or any other advice; it is provided for information purposes only. We have taken all reasonable care to ensure that the information contained herein is reliable, however it is unaudited and is subject to amendment.

This document does not constitute an offer to buy or sell investments. Nor does it express any views as to the suitability of investment to the individual circumstances of any recipient. Please note that past performance is not an indication of future performance. The value of investments can go down as well as up, and you may not get back the full amount invested. Changes in the rates of foreign exchange may cause the value of investments to fluctuate. Please note that the target returns described in this material are not guaranteed.

Before investing in any product of ABN AMRO, you should inform yourself about any legal or tax consequences, foreign exchange or exchange control restrictions, or any other requirements that you may encounter under the laws of your country.