The US advisory group, which advises institutions on over $1bn of assets, believes that hedge funds have been too aggressive in their strategy towards distressed companies. Hennessee explained that distressed hedge funds had seen a big increase in the amount of money being allocated towards the asset class, which has made hedging difficult and has forced managers to put money to work in companies such as WorldCom. Assets invested in distressed hedge funds increased nearly 100% to $17bn in 2001 according to Hennessee.
Investors were looking for a replication of what happened in 1991 when the economy pulled out of recession and distressed hedge funds saw an average return of 34.75%, according to the Hennessee Hedge Fund Index. Its Hedge Fund Distressed Index fell 1.77% in June.
"Companies with bad business models were able to raise capital via the high yield market with relative ease in the late 1990s," said Charles Gradante, managing principal of Hennessee Group. "Many of these companies currently have little to no net asset value, making them poor distressed investments with low probability of coming out of bankruptcy alive."
Hopes that the improving economy would bail investors out of tight credit markets appear to be misplaced as the Merrill Lynch High Yield Index lost 7.75% in June, its worst month ever.
But while distressed funds are floundering, short biased and fixed income hedge funds are, according to Gradante, outperforming the market.
Short biased managers have, says Hennessee, been shorting WorldCom since December 2001 when the stock was trading at over $14. The managers have since been able to cover their positions at below $1.
Fixed income hedge funds have been able to take advantage of the flight to quality which has seen managers rotating out of equities into bonds. Hedge funds have reduced their exposure to high yield bonds and moved into Treasuries, helping drive up the fixed income index.