Nadja Pinnavaia, head of Goldman Sachs Hedge Fund Strategies Group for Europe and Asia, explains why some hedge fund managers are delving into more illiquid, complex strategies to generate attractive returns.

Was 2004 a disappointing year for hedge fund performance?

Pinnavaia: Overall returns for the year were in the high single digits, which certainly isn't disappointing. Most hedge fund strategies experienced returns within one standard deviation of their mean returns, within expectations. Strategies such as event driven, equity long/short and multi-strategy all produced returns above their historical average. However, hedge funds did experience weak performance during the second and third quarters of 2004. In particular what caught media attention was the month of May, which was the first time in 10 years that hedge funds saw negative returns across all major strategies. 2004 was a challenging environment for all hedge fund strategies because many markets experienced narrow range-bound trading, and volatility was very low.

Equity markets also showed a high correlation, and were driven largely by what was happening in the price of oil. This resulted in difficult conditions for tactical traders. For equity long/short managers these conditions made it a challenging time to be a stock picker as stocks were not being driven by their fundamentals. In addition, low M&A deal volume and convertible bond issuance as well as increasing bond yields made it a difficult period for event-driven and relative value strategies too.

Is the hedge fund industry becoming overcrowded? Should we expect lower returns to be the norm going forward?

There are certain strategies that are naturally capacity constrained and where the overcrowding argument is more valid. For instance it's natural that when an arbitrage trade is easily accessible the returns will diminish. This has been the case with convertible bond arbitrage strategies where the source of issuance is cheap and entry barriers in terms of skill level are relatively low.

This is why, when we look at arbitrage strategies, we're looking to invest in managers who are at the cutting edge of arbitrage innovation. The constant evolution of financial instruments in the industry will enable new types of arbitrage opportunities to be exploited. We look for strategies with a high intellectual barrier to entry to ensure the opportunity can be protected. We've seen interesting arbitrage strategies using credit instruments as well as capital structure arbitrage.

In arbitrage strategies, we are not just looking at the managers, but also paying close attention to their opportunity set. Other strategies, such as equity long/short and tactical trading are not capacity constrained. Here we're looking for talented managers who can generate alpha.

Where else do you see interesting opportunities for 2005?

One area of focus for 2005 is the event-driven and special situation space. Here we see managers with opportunities in more complex transactions. This is the area where hedge funds meet private equity. We see hedge funds able to extract value in the public markets through structured transactions or corporate balance sheet restructuring as well as the private markets.

These new strategies necessitate longer-term investments and offer lower liquidity. But we don't see lower liquidity as a bad thing per se. Liquidity has to be commensurate with the strategy and return profile. Less liquidity is not a problem if you are being compensated for the extra risk you take.

Moreover, in these strategies, more frequent liquidity would compromise the opportunity set available to managers. These strategies inherently require managers to take a longer-term approach and have a stable pool of capital with which to take advantage of opportunities as they arise.

What is your outlook for Asia? Do you think Asia will be where Europe is today in five years time?

At the moment Asia is only a small part of the global hedge fund pie. Asian hedge fund assets are around $60 billion, which is only 7% of the global total of over $900 billion. But this doesn't reflect the huge demand and appetite for Asia that presents an exciting opportunity for generating alpha. The potential is significant, and in five years' time, Asia could be miles ahead of where Europe is today.

The challenges we may come across, though, are market-disrupting events and liquidity crunches, which could slow down the development of the industry in Asia.

How much of your portfolio is dedicated to Asia? What type of Asian strategies have you found interesting?

Currently, approximately 10-15% of our portfolios are invested in Asia including Japan. Our investment in Asian hedge funds is driven largely by bottom-up selection based on manager talent. The Asian hedge fund industry is largely dominated by long/short managers, most of which are long-biased.

For us to invest in a long/short manager, we have to be convinced that the manager is generating alpha on both the long and the short side, and we're beginning to see the transition towards this in Asia. Most of the opportunities we see in Asia are in the multi-strategy and multi-arbitrage space.