One of the inherent risks to investing in hedge funds is the inherent volatility of performance. A top fund today might be the worst tomorrow. In Preqin’s latest November Hedge Fund Spotlight report, which looks at this year’s top 100 performing hedge funds, only three funds feature on the list from 2013.
To qualify, only those funds with USD100m or more in AuM were considered. The sample period was October 2013 through September 2014.
What is clear from the list is that the top performing funds over the past 12 months are more volatile. Whereas year-on-year only three funds made the grade, when the performance period is widened out from September 2012 to September 2014, that number climbs to 10 funds.
This serves as a good example of the dangers of employing short-termism when investing in hedge funds. Before the financial crisis, investors sometimes tended to be too kneejerk and had unrealistic expectations. One bad year does not necessarily mean a fund is on an irreversible slide. High performance will always be accompanied by high volatility; that is the risk/reward pay-off.
In today’s markets, sticking with a manager’s convictions and investment philosophy can often be the best approach. And to be fair, with more institutional money in play, investors are taking a more pragmatic approach. Then again, larger funds that feature on the top 100 list actually have the lowest volatility – more on that shortly.
“There was quite a high turnover of funds on the list and shows that whilst the top performing funds might enjoy big wins, they also incur large losses. These funds tend to be smaller and more nimble in the markets but because of their volatility some investors might not favour the risk/return profile on offer,” says Amy Bensted, Head of Hedge Fund Products at Preqin.
Looking at overall performance, Bensted notes that the numbers are noticeably down on last year. “The top-level takeaway is really that these top performing funds have failed to hit the heights of last year,” adds Bensted.
2014 has been a challenging year given the level of geopolitical tension, falling oil prices, the Ebola outbreak, softening demand for commodities and Japan slipping in to recession.
Across all seven strategies in Preqin’s research, relative to their benchmark performance each strategy produced a similar level of performance. The top performing strategy with 27.51 per cent was macro, whilst the lowest performing strategy was relative value with 20.04 per cent with all five other strategies (long/short equities, asset backed lending, event-driven, CTAs and multi-strategy) falling within that range.
In terms of which strategies made up the top-10 performing funds on the list, it is perhaps no surprise that long/short equities dominate, accounting for 70 per cent of the funds.
Coming out on top was the India Capital Fund (A shares), run by India Capital, which has been investing in Indian public equities since 1994. Over the last 12 months the fund has returned 58.91 per cent. A more recent fund launch, Okumus Opportunistic Fund, which began trading 1 January 2013, ranked third on the list with returns of 44.34 per cent. Among other strategies, the best performing CTA fund, ranked four on the list, was Brummer & Partners’ USD366mn Lynx 1.5 (Bermuda) Ltd. fund, up 43.91 per cent.
Indeed, it’s been a more encouraging year for CTAs. Whilst they only account for 8 per cent of the total hedge fund universe, they represent 19 per cent of Preqin’s top 100 list.
“Within our research we found that long/short equity strategies have done well. Some CTAs did particularly well. Another finding is that European fund managers did better globally than other regional managers. They are over-represented in our results, which is quite interesting,” notes Bensted.
Specifically, 35 per cent of hedge funds based in Europe accounted for the top 100 list even though European managers only represent 21 per cent of total industry funds. UK-based managers were the best represented, with 12 funds. This suggests that European fund managers have been better able to navigate the current climate and generate good returns for their investors. With AIFMD in place and European managers having to become regulated there’s more pressure on them, which is perhaps also driving their performance.
That an India-focused fund is the top performer over the last 12 months is reflective of the state of Indian hedge funds in general. If one refers to the HFRI Emerging Markets: India Index, on a year-to-date basis the benchmark is up an impressive 43.84 per cent. Over the last 12 months, that figure rises to 49.42 per cent.
The HFRI World Index, by comparison, is up 5.35 per cent YTD.
Credit funds have had a disappointing year says Bensted, while some of the event-driven funds have seen performance drop off (after doing very well last year).
“In last year’s top-10 list there were more event-driven funds featured. I’m sure if we’d compiled the list from April onwards, for example, there might have been a higher representation from CTAs, which have done well since Q3 2014,” comments Bensted.
Even though the return distribution across all seven strategies was in a tight range, as one would expect when the sample set only consists of 100 funds, what is interesting in Preqin’s research is that there is a significant disparity of performance between the benchmark and the best performing funds in strategies such as macro.
As mentioned above, the top performing macro strategies returned 27.51 per cent. By comparison, the benchmark returned just 4.66 per cent.
Clearly, within global macro there are some great funds, but plenty that are not so great.
“Macro strategies aren’t a big focus for investors at the moment, despite market concerns. These figures show that one can find excellent macro funds but the overall benchmark is quite low suggesting that there are a good number of these funds that just aren’t performing well,” states Bensted.
On the flip side, strategies such as Asset-Backed Lending, have a much tighter range of performance. The top funds in this category returned 21.76 per cent whilst the benchmark returned 11.76 per cent. There is a much higher chance of allocating to good quality ABL managers than global macro given that the gap between the best and the average performance is less pronounced.
“Investors who are looking for more consistent returns may favour these types of strategies,” suggests Bensted. “It may be that funds that are generating 27 per cent returns or more are not suitable for pension funds because they might lose 27 per cent the following year; it’s a question that investors have to ask themselves.”
This comes back to the point about volatility. Preqin’s research found that the largest funds tend to be clustered towards the lower end of the performance spectrum; 52 per cent of the aggregate AuM of the 100 funds on the list originates from funds that are ranked in the fourth quartile. Moreover, these funds tend to exhibit a lower volatility profile (over a three-year period).
In many ways this reaffirms what the industry has known for some time: that the biggest funds in the industry are asset gathers not alpha generators.
“The biggest funds in the list with assets north of USD1bn might have a different outlook on the markets to smaller more nimble funds. They are less willing to take on risk due to the nature of their investors and the opposite is true for smaller funds. The point is there are lots of different funds achieving different objectives for different investors. The big name funds that most institutional investors allocate to are not necessarily employing the same levels of risk that they might have done 10 years ago. They offer lower volatility and this has enabled them to grow substantially,” says Bensted.
Of course, every investor is different in the same way that every fund is different. There are plenty of risk takers that are happy to allocate to smaller funds and interest in emerging managers – even among some institutional investors looking to build portfolios of emerging talent – continues to be strong. But as Preqin’s top-100 list emphasizes, the funds that are able to produce high octane returns have a high volatility profile and cannot be expected to produce eye-popping performance on a multi-year basis.
“We are seeing returns becoming a key requirement for investors again given the mediocre year the industry has seen,” says Bensted, who, in conclusion, provides the following thought:
“Hedge funds are not a completely liquid investment. They can’t be treated like cash machines to withdraw one’s capital any time necessary. That said, investors are beginning to take a longer term view and are not redeeming even though performance hasn’t been great. That applies to all investment portfolios, not just hedge funds. Over a five or 10-year period, hedge funds have been consistently producing returns that investors want on a risk-adjusted basis. The depth of understanding is definitely improving among investors.”
To read Preqin’s latest November Spotlight report in full, please click here