By ULRICH KELLER

IT IS widely known that alternative assets - and hedge funds in particular - have been hit hard by the financial crisis. But one should not discard an asset category because of misbehaviour by a certain group of managers.

Undoubtedly, overall results in the hedge fund sector were disappointing in 2008. But it is important to distinguish the good from the bad - and what is more important, to recognise the ugly.

At UBS Global Asset Management's Alternative Funds Advisory (AFA) we sought to identify the true cause of the underperformance. In fact, a review of the positioning of many of our hedge fund managers over the past year did not reveal a great deal to criticise. Indeed, in the main, our managers maintained well-constructed books.

The true source of risk was the meltdown of the interbank market and the resulting sudden drain of liquidity after the collapse of Lehman Brothers in September 2008. It is important to understand that the major part of the market was not just less liquid. In many asset classes, including structured products, OTC contracts and emerging market bonds, no trading was taking place at all.

A good indicator for illiquidity is the development of the so-called TED - the spread between US Treasury bonds and the Eurodollar interest rate futures - over time. In typical trading conditions the spread would be expected to be around 50 basis points, but as a result of the crisis, it moved to around 450 basis points - almost 10 times higher than normal (see chart).

The widening of the spread inflated the cost of short-term trading and exerted significant pressure on hedge fund trading positions across the board. Importantly, the widening spread was to some degree indiscriminate in its effect. Even well-constructed books suffered as a result of the market turbulence.

At the same time, the absence of liquidity made the scope for managing risk - that is, changing, hedging or exiting exposures - either extremely limited or impossible. In our view, this was the critical element driving event-driven and relative-value strategies, while extending also into equity-long/short.

On the other hand, global macro trading and systematic managed futures remained largely unaffected by the illiquidity, simply because they typically trade only the most liquid instrument classes, such as foreign exchange, futures and sovereign bonds.

We would suggest that the fact that these strategies were the exception from the rule underlines the case for the identification of market liquidity as the core driver of performance over the period.

Of course, not all hedge fund managers were running books sustainable for going into a crisis, and the ensuing shake-out will result in a number being discontinued. In our view, such a cleansing process is healthy and unavoidable, and we are encouraging certain managers to liquidate rather than continue with an inappropriate strategy.

Positive returns

Investor disappointment at underperformance in the hedge fund sector was compounded by the restriction of redemptions promoted by the illiquid market. This was done either by installing gates - that is, imposing limits on the amount to be withdrawn over a defined period - or by issuing an illiquid side pocket. In contrast, most professionally-managed funds-of-funds were, to some extent, insulated against illiquidity and fared better than the sector in general.

None of the UBS Alternative Funds Advisory core diversified portfolios, which include the UBS Alpha Select Fund, UBS AFA Trading Fund and UBS A&Q Alternative Solution, had to restrict liquidity. Typically, AFA allocates strongly to global macro trading and/or systematic managed futures. Indeed, managed futures was, by far, the best-performing hedge fund strategy in 2008 and allowed the UBS Alpha Select (A-shares) fund-of-funds product to out-perform the HFRI Fund-of-Funds Composite Index by 455 basis points.

With the TED spread falling below 100 basis points this year and currently trading safely below 50 basis points, financial markets have normalised to a great extent. At the same time, while pockets of illiquidity remain, they no longer constitute a systematic market factor, and redemption pressure for most hedge fund managers has been digested. Accordingly, most managers consistently produced positive returns so far in 2009.

Hedge funds were, on average, in positive territory in January and February, when the markets were strongly down, as well as in March and the following months, when the markets were up, demonstrating their unique potential to deliver positive returns in falling as well as in rising markets. In fact, given the normalisation in the market, well-diversified hedge fund portfolios have every chance of being among the better-performing asset categories in 2009.

The writer is chief investment officer of Alternative Funds Advisory (AFA), a business unit of UBS Global Asset Management providing investment services in hedge funds, private equity and infrastructure

This article was first published in The Business Times.