With hedge fund returns under performing the S&P by more than 7%, it’s fair to say that 2011 was a bad year.  Average losses of 5% in 2011 (the second year to report losses in twice as many years) found fund managers wishing for something—almost anything—to change.

Holding markets hostage, of course, is the Eurozone debt crisis, which has been not only severe but also excruciatingly long.   Worse than the crisis itself is the sense of disorientation: the market takes daily flights of fancy, yet long-term decision making remains inert.

But what’s stale news to the average observer finds fund managers still in a frenzy.  Increasing complexity within the Eurozone situation has served only to make things worse.  Anonymously, fund managers tell a dismal tale, one of scrambling to develop predictive models in an information vaccuum, of billions lying in wait to invest.

A Threat to the Hedge Fund Model

Hedge fund profits are found at the intersection of data-driven risk-taking and speculation.  But, what happens when scenarios are too complicated to predict?

Prolonged Greece default drama occurring simultaneous to five other member nations in serious trouble is a “one-two punch” nobody saw coming.

The absence of precedents and scenario models to anticipate the outcomes render next steps uncomfortably obscure.  “A hedge fund may have a hedging program that is very highly attuned to dealing with its positions. But the day after something happens there’s no program to deal with this and their hedge may be denominated in a new currency,” said an anonymous Chief Risk Officer to Reuters last week.

The sentiment was echoed by Imagine Software CEO Lance Smith, who discussed the failure of traditionally reliable KPIs like value at risk.  “A traditional measure of risk like VaR has nothing to say on this…A euro break-up could be a 7 standard deviation event. A 6.5 standard deviation event occurs once every 34 million years, while a 50 percent fall in the Eurostoxx would be a 21 standard deviation event. This just highlights the flaws in a standard statistical approach.”

Legal Foibles Aren’t Helping

Complicating the matter of asset valuation are questions about what happens if obligations aren’t met.  Apart from ambiguous recourse rights of creditors is the alarming trend of debt issuers using legal loopholes to restructure deals.

Distressed sovereign debt can be particularly tricky to predict, according to Mark Cymrot, an attorney with Baker & Hostetler LLP, who defended Peru in 1990s lawsuits filed by banks seeking sovereign debt repayment.  “You have to have a long time horizon,” he said. “One of the biggest problems is even if you get a judgment in your favor, there’s still no guarantee you can actually collect.”

From Risk-Loving to Risk-Averse

Uncertainty has made some of the most unshakable investors skittish, turning confident, risk-loving types into risk-averse.  “It’s hard for us to come up with an investment thesis that makes it interesting,” said Robert Rauch, a partner at Greenwich hedge fund Gramercy Advisors, of the decision of whether to invest in Greek debt. “It’s not clear to us that out of this process you can make any money.”

Additional discord on predictions resounded in a Debtwire Distressed Investor Survey that interviewed 100 hedge fund managers, prop desk traders and long-only managers.  41.2% of respondents said they expect European restructurings to hit a peak in the first half while over a third (37.1%) expected it to be in the second half of 2012.

So, how are funds valuing European investments?

Funds wishing to form some opinion (however tentative that might be) are interested in three scenarios:  a Eurozone that remains intact but sees some degree of economic shrinkage, a partial Eurozone collapse with the exit of at least one member country, and a total Eurozone collapse that sees significant restructuring of member country ties.  Key questions involve the nature and degree of shrinkage (a recently printed figure, 3% seems low), and the timing required to understand and implement any structural changes imposed to the currency or on the region.

Yet, a dearth of good information and an oversupply of variables still hamper speculation around even big picture scenarios such as these.  “There’s just a news vacuum,” said James Paulsen, the chief investment strategist at Wells Capital Management. “If you just get Greece to come out with anything, you can actually maybe have people move on. I do think they are going to come out with some sort of agreement. That would be a big step forward in dealing with Europe’s debt crisis.”