By Simon Gray – The global hedge fund industry has just suffered its second losing year in four, yet the mood across the industry today is optimistic, albeit cautiously so. Last year’s overall sub-par performance across the sector, albeit with a few significant exceptions, appears to have been accepted with relative equanimity by an investor base conscious that they were not missing out on spectacular returns from other investment classes.
What was striking about hedge fund performance in 2011 was its increasing compression, according to data provider Hedge Fund Research. While the HFRI Fund Weighted Composite Index declined by 5.26 percent, constituent fund dispersion narrowed to its lowest level since 2006, with the compression concentrated in fewer positive outliers. The worst performing decile of the broad based composite declined by 30.7 per cent last year, while the top decile gained 19.5 per cent.
This implies a top-bottom dispersion of just over 50 per cent, down from nearly 58 per cent in 2010 and more than 100 percent in both 2008 and 2009. According to HFR, last year marked the lowest average performance for the top decile, by a significant margin, since the firm began tracking this data in 2000; the previous lowest performance by the top HFRI decile was a gain of 39.2 in 2002.
The other notable feature of the industry in 2011 was the highest level of hedge fund launches since the total of 1,197 in 2007, just before the crisis erupted. Last year saw 1,113 new funds launched, including 270 in the fourth quarter, although 775 fund liquidations, including 190 in the final three months of the year, represented a slight increase from 743 in 2010.
The largest concentrations of new launches were in equity hedge strategies, with 479 (the highest total in this category since 2006), and macro, with 265 (the highest total since HFR started tracking the strategy in 1996). However, the 293 equity funds that were shut down represented the largest number of liquidations in the strategy since 651 funds closed in 2008. By contrast, the number of fund of hedge funds closures fell to 215, the lowest level since 2007. HFR says slightly more funds were launched in the US than in Europe, while liquidations were higher in Europe; it had been the other way round in 2010.
“Despite performance volatility and macroeconomic uncertainty in the second half of the year, investors maintained a strong commitment to hedge funds, and fund managers expanded the scope and breadth of strategies offered, making 2011 the strongest year for new launches since the global financial crisis,” says HFR president Kenneth Heinz (pictured).
“While some have suggested that increased regulation may deter new fund launches, many hedge funds are launching not only as a result of increasing investor risk tolerance, but also as a result of these regulatory changes to trading activities and risk oversight at financial institutions.”
Focus on downside protection
One lesson that managers have learned from the chastening experience of 2008, of the importance of communication with investors, may have helped to keep redemptions, and fund closures, in check in 2011, especially in an environment where many investors have struggled to make sense of the market’s fluctuations.
“Historical returns are not very good at describing the current risk environment,” says Eric Bissonnier, partner, chief strategist and chairman of the global investment committee at Swiss-based EIM, winner of the Hedgeweek Global Award for Best Specialist Fund of Hedge Funds Manager. “We use a lot of forward-looking work that describes the world today, anticipating a range of probable scenarios. We make sure we’re conscious of that, and that our clients understand what it means for their portfolios.”
Multistrategy funds were among the beneficiaries of the market environment, including Barclays World Tactical Opportunity, a multi-asset absolute return strategy that won Barclays Capital Fund Solutions the Hedgeweek Global Award for Best Multistrategy Fund Manager. “A key attribute of BWTO is its level of flexibility,” says head of Swiss and German sales Gil Platteau.
“It is designed to cope with the high volatility that we saw last year and focuses on downside protection. Dynamically reallocating to appropriate asset classes each month allows the portfolio always to be aligned with underlying market conditions and to reduce risk quickly when markets shift. Last year we not only preserved capital but generated positive returns, validating the strategy and highlighting its added value to investors.”
Lyxor Asset Management, which won the Hedgeweek Global Award for Best Managed Account Platform, added multistrategy funds to its platform for the first time in 2011, although head of research Stefan Keller notes: “This represents a new frontier for the industry, as you must dominate various technological and legal challenges to replicate such complex strategies in a managed account framework.”
There is some evidence for the view that the industry’s more difficult operating conditions since 2007 have contributed to the gradual erosion of its traditional 2-and-20 fee structure. HFR says management fees averaged 1.57 per cent during the final quarter of 2011, down by just one basis point from a year earlier, but at 18.71 per cent, average incentive fees were down by one basis point from the previous quarter and 24 bps since the end of 2010.
In other respects, though, changes to the industry environment such as the introduction in the US of the Volcker Rule, which imposes severe constraints on proprietary trading by banks, stand to benefit independent fund managers such as PIMCO, which won the Hedgeweek Global Award for Best Relative Value Fund Manager.
“The competitive landscape is limited for relative value volatility strategies,” says product manager Min Xiao. “Proprietary trading desks are closing and the hedge fund community too has a much smaller asset base than pre-crisis. While dislocations in the markets have become more frequent and extreme, the competition in chasing those dislocations has diminished materially.”
Crunching the fund numbers
According to HFR, the total number of hedge funds worldwide funds rose to 9,523 at the end of 2011 and industry assets increased by 3 per cent to USD2.02trn, but there is much debate about the accuracy of industry statistics that rely on manager statements because of well-known problems with self-reporting.
HFR’s numbers are not far off those compiled by UK financial sector promotional body TheCityUK, which puts the number of funds last year at 9,800 (three-quarters of them single-manager funds, the rest funds of hedge funds) with assets down 3 per cent at USD1.90trn. But surveys of hedge fund administrators tend to produce numbers at least 50 per cent higher – currently around 16,000 funds and as much as USD3trn in assets. Compilers of hedge fund asset and capital flow statistics themselves struggle to explain the wide discrepancies between the two approaches.
There has been much discussion of the advantageous position enjoyed since the crisis by Asian hedge fund managers by comparison with their colleagues in Europe and North America, but the figures being reported are ambiguous. According to one recent survey, Asian hedge funds started by both new and existing managers raised USD4.43bn in 2011, the highest amount since USD7.8bn in 2007 and led by multistrategy funds with USD2.7bn. The average size of the 58 Asian hedge funds established last year rose to USD76.4m from USD40m in 2010.
Asian managers, certainly the larger ones, are following the trend elsewhere in the world to adopt a multi-prime model. According to Harvey Twomey, head of global prime finance distribution for Asia-Pacific with Deutsche Bank’s Global Markets business in Hong Kong, says the market began moving toward a more diversified approach to prime brokers more than five years ago.
Deutsche Bank, which won the Hedgeweek Global Award for Best Asian Prime Broker, has been a major beneficiary of the shift. Says Twomey: “In recent years our market share has grown in this region as we have been mandated at inception by an increasing share of new fund launches, as well as existing clients on the platform growing in terms of assets under management.”
But the picture in Asia is not entirely positive. A total of 67 Asian-focused hedge funds are reckoned to have shut up shop last year, the first time that closures have outnumbered openings since 2008. A report from Singapore-based data provider Eurekahedge says net outflows in the final four months of the year left the Asian industry with USD124bn in net assets at the end of December 2011, down from a peak of USD176bn four years earlier.
Industry asset levels have been depressed by the closure of hedge fund firms such as Thaddeus Capital, which had USD300m in assets under management, and Boyer Allan Investment Management, which at one time managed USD1.8bn. More may follow, since Eurekahedge estimates that 65 per cent of Asia funds are below their high water mark, so they cannot obtain performance fees, compared with 50 per cent or less of the industry worldwide.
Performance rebound in 2012
Analysts blame the fact that Asian funds are disproportionately long-biased – in part because short-selling is more difficult that in Europe and the US, due to a substantially smaller pool of stocks available to borrow and lower market turnover – for their average performance decline last year of 8.5 per cent, according to Eurekahedge (the HFRI Asia ex-Japan Index was down 18.2 per cent), compared with around 5 per cent for the industry as a whole.
Outflows and performance losses have compounded the sector’s problems by reducing average fund sizes, further depressing managers’ income. Eurekahedge says that around 42 per cent of Asian hedge funds managed assets of USD20m or less by the end of last year. But potential investors may be encouraged by the rebound seen among Asian funds over the first few months of 2012, with the HFRI Asia ex-Japan Index gaining 10.54 per cent in January and February, in line with an overall gain of 9.31 per cent for all emerging market hedge funds (which lost on average 13.8 per cent in 2011).
Indeed, performance at the start of this year for the industry as a whole has done much to dispel the gloom that hung over hedge funds in 2011. According to Hennessee Group, an adviser to hedge fund investors and data provider, the Hennessee Hedge Fund Index rose by 4.07 per cent in January and February.
Although hedge fund gains are lower than those of the major US stock market indices, which ranged from 6.02 per cent (Dow Jones Industrial Average) to 13.89 per cent (Nasdaq Composite) over the same period, the firm sees grounds for optimism. “Hedge funds are off to their best start since 2000,” says Hennessee Group co-founder Charles Gradante.
“During the first two months of the year, hedge funds have benefitted from a better investment environment relative to 2011, with improved investor sentiment, greater risk-taking, lower correlations and lower volatility. Markets are responding to fundamentals, which is benefitting stock-pickers. While many risks remain, there is optimism around a better economic outlook for the US and stability in the Euro zone.”
Co-founder Lee Hennessee says that hedge funds generated gains in February despite conservative exposures and as the investment environment improves, managers have increased exposure levels toward historic norms. Nevertheless, she notes that managers remain cautious: “Funds are prepared to adjust exposure quickly should conditions dictate, as many feel volatility may rise from currently subdued levels.”
Gradante adds: “There are some similarities between the beginning of 2012 and early 2011, and several managers have expressed some concern about a potential correction. The S&P 500 has rallied by 20 per cent since October, and investor sentiment may be peaking. Some managers feel that the markets are overbought and are due for a short-term correction.”
Volatile fund capital flows
One of the firms that has enjoyed the change in the economic and financial environment in 2012 is Liongate Capital Management, winner of the Hedgeweek Global Award for Best Diversified Fund of Hedge Funds Manager. Last year, according to managing director Jeff Holland, both fundamental and systematic managers struggled even to preserve capital amid spikes in volatility and exceptionally high correlation between asset classes.
However, Liongate’s flagship fund is up almost 3 per cent in January and February. “Last year the preservation of capital became paramount in order to be ready to redeploy capital to emerging opportunities, but this year is more encouraging,” Holland says. “We’ve entered 2012 with a more nimble book of managers. Opportunities are improving as correlations break down, and we are using this to reallocate capital to conviction ideas.”
Despite the tricky market environment in 2011, across the global industry investors appeared resigned rather than angry; there was no repeat of the spike of redemptions seen in the wake of the average 20 per cent losses endured by hedge funds in 2008. According to TheCityUK, hedge funds enjoyed USD70bn in new inflows last year, although its distribution was uneven, to say the least.
Its report says USD150bn in net inflows during the first half of 2011 continued a trend seen in the second part of 2010, but the final six months saw net outflows of around USD80bn, largely as a result of increasing concerns about the European debt crisis, slowing global economic growth and heightened market volatility. However, TheCityUK believes net hedge fund inflows should resume this year as institutions increase allocations to alternative investments – a view supported by Deutsche Bank’s recent survey of institutional investors.
One firm that did not find capital-raising as difficult as most last year was London-based Dalton Strategic Partnership. The winner of the Hedgeweek Global Award for Best Long/Short Equity Fund Manager was able to hard-close both the Cayman-domiciled Melchior European Fund and the Ucits-compliant Melchior Selected Trust: European Absolute Return fund, which follow the same investment strategy.
“The whole strategy has now hard-closed,” says Dalton managing partner and chief executive Magnus Spence. “We raised a lot of money in the first half of the year as people saw that we could protect capital in difficult years like 2008.” The Cayman fund closed at USD100m in October, while its Ucits counterpart closed in July with assets of USD600m.
Surveys of capital flows for the beginning of this year are contradictory. BarclayHedge and TrimTabs Investment Research reported that investors redeemed an estimated USD15.2bn (0.9 per cent of assets) from hedge funds in January, although performance gains meant that overall asset levels rose. “January marked the biggest monthly outflow since July 2009, when hedge funds redeemed USD17.7bn,” says TrimTabs analyst Leon Mirochnik. “The hedge fund industry has experienced net outflows in four out of the last five months.” Only fixed-income, multistrategy and merger arbitrage funds have seen net inflows since September.
However, a more optimistic picture is painted by fund administrator GlobeOp, which obtains capital flow data from the USD174bn in hedge fund assets it services. According to the GlobeOp Capital Movement Index, net subscriptions to hedge funds amounted to 2.1 per cent of total assets in February, following inflows equivalent to 2.22 per cent of assets in January.
Chief executive Hans Hufschmid told Reuters that investors seem more settled after a bad year for markets overall in 2011: “In the last two or three months the uncertainty about Europe has settled down a bit, the economic numbers in the US are looking pretty positive, and people are happier to allocate to hedge funds.”
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