Deutsche peeks over the hedge

Hedge funds across the world have come in for some criticism in the wake of the US-inspired financial crisis. They have been accused of exacerbating the fragility of world markets and even causing the problems in the first place, with their tendency to invest in complicated and risky financial instruments.

Not much of this criticism was well-judged or accurate. In a crisis the temptation is to look for somebody to blame, and the hedge funds, with their arcane and seemingly secret methods – not to mention the substantial compensation packages available in the business – made them easy targets.

So I am pleased to be able to report that, far from being a bunch of financial nerds greedily counting their loot, the hedge fund experts at Deutsche Bank are open, persuasive and ready to explain the detail of their sometimes opaque business. Indeed, they will be doing just this to a gathering of potential investors in Dubai today in what might be described as a bout of financial "speed dating" in which Deutsche fund managers will meet and cultivate as many investors as possible.

To give the Dubai meeting something to break the ice, Deutsche's global markets team has produced its annual survey of the hedge fund industry, and I was led through its findings yesterday by two Deutsche executives, Sean Capstick and Penry Jackson, who managed to ditch the jargon and explain the prospects for the business in a clear and analytical manner.

The Deutsche survey is probably the most comprehensive piece of research conducted by a major investment bank into global investment trends in the hedge fund industry. With more than 1,000 professionals surveyed, with responsibility for about $1 trillion (Dh3.67trn) of funds, it is an invaluable analysis of the current situation, and estimate of future prospects. The big picture emerges from it with clarity.

After the second half of last year, when the hedges suffered along with the rest of the financial world, the hedge fund mood nearly mid-way through 2008 is cautious, even bearish. Some 80 per cent of respondents were pessimistic on global economic prospects for the rest of this year. This fact was underlined by one of the report's main findings – that 30 per cent of the hedges were sitting on cash, amounting to some $75 billion.

This sober mood was further underlined by the fact that fewer hedge funds are going to leverage up in their investment portfolios. They have learned their lessons from the market falls of last year, and will not risk over-extending themselves in the current climate.

In fact, the industry spends much of its time now assessing risk as one of the key factors determining policy. Risk management now takes its place alongside the "3 Ps" – performance, philosophy and pedigree – in the hedge fund manager's mantra of investment criteria. Generally speaking, the bigger the organisation managing the fund, the lower the risk – though investors might have to sacrifice some performance for the greater security. Overall, investors want a better view of what happens to their money while the manager has it, reflecting the new risk-averse atmosphere.

The picture changes for next year, however, when 40 per cent of fund professionals see an improvement in the macro-economic situation, compared to only seven per cent his year.

And for the Gulf, indeed for the whole of the Middle East and North Africa, there is more good news.

Nearly half of the respondents told Deutsche that the Mena region would be the best performing this year, taking the top spot from Asian giants China and India. Russia and Latin America are also backed to be sound performers.

On Mena, Deutsche says the demand for access to the region by international investors has been constant, as has the need for capital from the big energy rich states of the GCC. In Dubai, in particular, Deutsche sees the emirate acting almost as a "proxy" for the rest of the area. Dubai has reached such critical mass in its diversification away from energy dependency that it has virtually usurped the role of financial capital from the more conservative centres in Abu Dhabi and Saudi Arabia. The attitude of government in freeing up the investment regime is regarded by Deutsche as critical in this process, and the bank hopes there will be further progress in this field, especially in relation to the restrictions on how much of a UAE company can be owned by foreign investors. Further action from the federal government would be appreciated.

A lot will also depend on whether the markets in Dubai and Abu Dhabi can capitalise on the desire of UAE family owned businesses, as well as those still owned by the government, to raise capital on the country's stock markets. Increased foreign investment can only be good for the UAE's financial culture, Deutsche argues, producing a diverse and sophisticated group of investors.

The flip-side to the attractiveness of the Mena region is the general pessimism surrounding North America and Western Europe, which many managers believe will be the worst performing regions this year. China too has fallen down the rankings, on scepticism that the phenomenal rates of economic growth shown in recent years can be sustained.

By sector, those funds based on a broad macro-economic strategy seem destined to have the best prospects for the rest of this year, followed by distressed and equity volatility investments. Arbitrage in corporate takeover activity will be the least successful, Deutsche says, reflecting the fall-off in mergers and acquisitions business in the wake of the credit crisis.

The new financial reality has also led to an increase in the acceptability of the "lock up" where investors' funds are tied into a specific time frame. Some groups of investors – banks, corporates and insurers, for example – are more willing to accept a one year lock-up, and there are some – pensions, endowments and foundations – which will even agree to three-year deals. In this respect, the hedge fund business is beginning to show some of the characteristics of its related "cousin", private equity.

Two final findings of the report show the hedge fund industry in perhaps its most optimistic mood. While capital inflows in the first quarter were slow, the industry still expects $200bn of new cash to come into hedge funds over the current year. And, while investors estimate that the industry overall will show a return of 7.5 per cent this year, they believe their own rate of return will be 10 per cent. That's optimism for you.