Hedge funds are continuing to ride out the volatility caused mainly by the eurozone crisis, as market participants believe that the sector is in good health as long as dispersion remains in the markets.

Hedge funds began the year brightly, posting their best start to a calendar year since 2000, but monthly declines in March, April and May have seen year-to-date gains reduced to just 2.5% across all main strategies globally, according to recent data from Chicago-based Hedge Fund Research (HFR), a provider of data and analysis to the alternative investment industry.

This year has been interesting; it was a great start to the year for hedge funds, the best in over a decade,” Mark Parsonson, executive director of UK-based fund of hedge funds manager Liongate Capital Management, told Markets Media. “Once again 2012 is beginning to look a lot like 2011 and 2010, a strong start to the year macro-economically, then the markets have again taken a bit of a knock on European concerns and a slowdown in data.

“As a result, hedge funds have given back some of their early year return but they are still well ahead on the year and outperforming a lot of major indices.”
 
Last year, hedge funds struggled as long periods of volatility later in the year, coupled with the mass correlation of markets, caused many to post losses. Hedge funds generally struggle to post gains if markets all move up and down simultaneously. Globally, hedge funds posted losses of -4.8% for 2011, according to HFR, only the third calendar year decline since 1990.

“We’re seeing different trading behavior from hedge funds this year—managers are adapting to managing the types of risk we saw last year when you were getting market reversals: either risk management and deployment has become a lot tighter or hedge funds have become more aware of what can work in these periods of volatility,” said Parsonson. “In this respect, hedge funds appear to be well suited to what could potentially become a really difficult environment for traditional asset returns.

“Last year, interestingly, there was volatility but it wasn’t as significant as 2008—the volatility moves were high but not as extreme “It was the duration that was longer last year than 2008—by some measures it was the third longest period of equity market volatility for over nearly a century of history. This pushed correlation high. Correlation was the major problem in markets last year. Asset classes and individual assets, like stocks, were moving together, they were going up together and down together—this year that correlation has broken down significantly. 
 
“Dispersion is important. Hedge funds have the ability to do well in volatile markets as long as there is dispersion. They can exploit that dispersion by being long assets that are going up and short assets that are going down. If they are all doing the same thing, it is very difficult to make money for active managers, both long-only and hedge funds.
 
“What we’re seeing this year, despite the rise in volatility again, is that we’ve seen an increase in correlation but not to the extremes of last year. If the market continues to focus on fundamentals, looking through some of the significant tail risks, then for hedge funds the opportunities for active management are high, even in the face of volatility. If that dispersion stays in the markets, we would expect hedge funds to do well.”

Mirroring trends across financial markets, hedge fund performance during May was widely divergent across strategies, with macro strategies performing well, for instance, but equity funds less so.

“During the volatile month of May, investors reacted to increased European bank and sovereign bond risk and weakening U.S. economic data by aggressively moving portfolios towards less risky exposures,” said Kenneth J Heinz, president of HFR.