Thursday, December 31, 2009

2009 Key Trends in Global Fund of Hedge Funds

Introduction

2009 has been a year of mixed fortunes for funds of hedge funds, witnessing record redemptions through most of the year while at the same time, posting one of the best performances year-to-date. The Eurekahedge Global Fund of Funds Index has gained 9.17% November YTD and is on track to have the best year since 2003. In terms of asset flows, however, 2009 has been the worst year on record, witnessing net redemptions of US$164 billion November YTD.

The fund of hedge funds industry currently comprises 3,110 funds, almost 15% down from end-2007 which collectively manage US$440 billion. The assets under management figure has decreased by almost 50% from its maximum of US$823 billion in May 2008, primarily driven by the widespread redemptions. The notable difference between the decline in the number of funds and assets in 2008 and 2009 is attributed to most of the industry’s assets being eroded by performance losses and redemption requests rather than only widespread closures.

Although funds of funds started the year with two straight months of outperformance over single-manager hedge funds, multi-managers have not been able to match the strong gains made by underlying managers since then. Hedge funds have, on average, gained 18.34% November YTD as opposed to 9.17% for funds of funds. Furthermore, multi-managers also largely underperformed the single-managers in 2008 – the Eurekahedge Global Hedge Fund Index shed 11.6% during the year while the Eurekahedge Global Fund of Funds Index lost 19.6%. On average, funds of funds have only managed to outperform hedge funds in 18% of the months since 2000.

Figure 1 shows the growth in the number of funds of funds and the assets under management since 2000.

Figure 1: Industry Growth over the Years



This report is broadly divided into two parts – covering asset flows and performance review. The section on asset flows will look at the fund of funds industry in terms of manager locations, geographic mandates and strategic mandates over the last three years while the performance review examines the salient features of fund of funds’ performance. Additionally, we will also be drawing parallels with the hedge fund sector to compare the relative merits of investing through fund of funds versus directly into a single-manager fund.

Asset Flows

Table 1 gives a snapshot of the monthly asset flows across the fund of hedge funds industry since the start of 2008. Along with the losses suffered amid the steep market downturn, 2008 had seen massive redemptions in the second half of the year. As mentioned by Eurekahedge in the June 2009 report[1], not only has this trend continued through most of 2009, but the amount of assets withdrawn through the year exceeded the redemptions seen in 2008. Furthermore, the amount withdrawn from funds of funds accounted for more than 50% of the net redemptions seen in the single-manager space in 2008 (US$119 billion) and further increased to more than 60% in 2009 (US$164 billion).

In terms of positive flows, there were two months in 3Q2009 when the industry saw net positive flows, but most months have not witnessed significant subscriptions. This is due to a number of reasons, such as a reduction in investor confidence after the Madoff scam and the increasing number of investors now allocating directly into hedge funds rather than going through multi-managers in their quest for better risk-adjusted returns. Significant outperformances by hedge funds in 2008 and 2009 contributed to this change in investor behaviour as well as the attractiveness of having only a single layer of fees. Since the inception of Eurekahedge indices in December 1999, funds of hedge funds have only outperformed single-manager hedge funds for 18% of the months. As a result, we expect the hedge fund industry to continue growing in terms of assets at a greater rate over the next year than the fund of funds industry.

Table 1: Monthly Asset Flows across Funds of Hedge Funds

Month
Assets at start
Net Growth (Perf)
Net Flows
Assets at end
Jan-08
808.7
(13.6)
22.7
817.8
Feb-08
817.8
6.7
(9.9)
814.7
Mar-08
814.7
(12.2)
23.7
826.2
Apr-08
826.2
4.0
(9.3)
820.8
May-08
820.8
8.7
(6.4)
823.2
Jun-08
823.2
(5.5)
1.9
819.6
Jul-08
819.6
(12.3)
(4.3)
803.0
Aug-08
803.0
(7.1)
(6.3)
789.5
Sep-08
789.5
(34.2)
(44.7)
710.7
Oct-08
710.7
(28.5)
(36.1)
646.1
Nov-08
646.1
(9.6)
3.0
639.5
Dec-08
639.5
(9.9)
(50.6)
578.9
2008
808.7
(113.5)
(116.3)
578.9
Jan-09
578.9
2.9
(72.2)
509.7
Feb-09
509.7
(0.7)
(32.2)
476.8
Mar-09
476.8
(0.5)
(8.7)
467.6
Apr-09
467.6
0.70
(14.6)
453.6
May-09
453.6
9.96
(16.3)
447.3
Jun-09
447.3
1.33
(6.2)
442.5
Jul-09
442.4
4.55
(13.4)
433.7
Aug-09
433.6
3.23
1.50
438.4
Sep-09
438.3
4.78
1.57
444.7
Oct-09
444.7
(0.1)
(3.9)
440.3
YTD Oct-09
578.9
26.1
(164.6)
440.3
Note: All figures in US$ billion.
Source: Eurekahedge


Manager Location

Figure 2 shows the change in the distribution of assets under management by manager location in 2007 and 2009, respectively.

The most significant change in the fund of funds space is the decline seen in the AuMs of Switzerland-based funds. Swiss multi-managers suffered greater losses than the global average during the financial turmoil in 2008 and 2009. While the global fund of funds industry shrank 47% between July 2008 and July 2009, the size of Switzerland-based funds of hedge funds declined by more than 70% in the same period. This is attributed to worse-than-average performances, large number of closures and continued redemptions. Furthermore, Swiss multi-managers were also substantially hit by the Madoff scam, which left many funds of funds exposed to the Ponzi scheme. Additionally, as opposed to quarterly gates imposed by most US and UK funds of funds, multi-managers in Europe continued to allow monthly redemptions, which also spurred outflows from those based in Switzerland.

Figure 2: Fund of Funds AuMs by Manager Location





Most of the market share has been gained by US-based funds of hedge funds, where new regulations aimed at protecting private clients are under consideration, hence, attracting those investors who suffered significant losses from their allocations to European multi-managers. Furthermore, US-based multi-managers have outperformed their European counterparts historically as well as in 2008 and 2009 – the average European multi-manager has delivered 8.3% November 2009 YTD while the American has returned 13.5% over the same period. Since its inception in December 1999, the Eurekahedge European Fund of Funds Index has gained 56% while the Eurekahedge North American Fund of Funds Index is up 74% and this considerable difference in performance is seen as a major reason for the change in the AuM demographics.

It is also noteworthy that the Asia Pacific region has more than doubled its share of fund of hedge funds assets from less than 2% in 2007 to 4% in 2009. This is partly due to the region offering well-developed financial centres such as Singapore and Hong Kong, a skilled, English-speaking talent pool at competitive costs, a host of hedge fund service providers and a growing investor base, making it an economical yet efficient place to operate. Additionally, Asian single-manager funds offer more attractive investments for multi-managers as they have been posting significant gains over the past few years – Asia ex-Japan investing funds have gained 87% in the last five years.

Regions

Figure 3a-3b: Breakdown of Industry Assets by Regional Allocations

Figures 3a and 3b show the invested regions by fund of funds managers over the past three years. As of October 2009, fund of funds managers allocated 50% of their clients’ capital into North American hedge funds, which is the largest allocation among the five groups. This comes unsurprising as the US still remains the largest capital market. In addition, the percentage of managers allocating to North American hedge funds has increased from 40% in October 2007 to 50% as of October 2009. This is partly due to the abundance of hedge funds (of all shapes and sizes) investing in North America and their consistent performance in recent times – the Eurekahedge North American Hedge Fund Index is up 25% since 2006 while the European Hedge Fund Index has only gained 2% over the same period. Another important reason for the percentage increase in North American allocations is that North American funds did not suffer as much as the other regions during the downturn in 2008, ie allocations to regions other than North America have declined to a greater extent.

Figure 4 shows the regional performances of funds of funds as depicted by the Eurekahedge indices. The best performing hedge funds in the past three years have been those that were invested into emerging markets, followed by those that invested into North America.

Figure 4: Fund of Hedge Fund Relative Performance by Regional Investment Mandate

Strategies

Figure 5a-5b: Breakdown of Industry Assets by Strategic Allocations



If we break down fund of funds investments by their respective underlying strategies as seen in Figures 5a and 5b, we observed that most fund of funds managers have distinctly increased their allocations to multi-strategy funds and reduced their allocations to global macro-theme funds. We find this surprising as macro hedge funds have, as shown in Figure 6, produced a more consistent performance over time and have outperformed hedge funds that are focused on multiple strategies. Looking at the same graph, we note that global macro funds as a whole tend to have lower volatilities than multi-strategy funds. In terms of beta performance from November 2006 to October 2009 (and taking the MSCI World Index as the proxy for equity markets), global macro funds have beta of about 0.097 while multi-strategy funds have higher beta of about 0.249.

Figure 6: Relative Performance of Global Macro Hedge Funds and Global Multi-Strategy Funds



Fund of funds managers continued to be overweighted on long/short equities and have increased their allocations to the strategy over the last three years. The 22% portfolio exposure to long/short equities in October 2006 has increased to 26% in 2009. However, the allocation to long/short managers took place prior to the run-up in global equities seen recently as shown in Figure 7. The increase seen in 2007 is partly due to the growth of emerging markets funds, which primarily have a long/short equity focus. However, fund of funds allocations to long/short equities remain lower than the proportion of long/short equity funds in the hedge fund universe as a greater number of investors understand the equity markets and hence, it is easier for single-manager funds to raise capital for the equity-based strategy directly from investors. On the other hand, investors who do not understand the more complex models employed by some hedge funds prefer to go through fund of funds in their quest to allocate to the various strategies available. 

Figure 7: MSCI World Index versus FoF Allocations to Long/Short Equity Managers



Besides multi-strategy and equity-related funds, fund of funds managers allocated more capital to fixed income strategies during October 2006 to October 2009. Most managers have kept their allocations to distressed debt unchanged but in the past few months, distressed debt investing has proven to be one of the most profitable strategies since the rebound of equities in March 2009. Event driven funds have also seen a decline in investments primarily because of the lack of corporate action activities (outside of distressed buyouts et al) such as mergers and acquisitions during the market decline.

Trends in Capital Raising

Funds of funds and hedge funds show some interesting trends in their comparative asset flows. Table 2 shows the maximum drawdown in the two sectors witnessed over the 2008 to 2009 time period.

Table 2: Average Drawdowns in Funds of Funds and Hedge Funds

Largest Drawdowns in AuM

FoF
HF
Period
June 2008 to July 2009
June 2008 to April 2009
% Decline
-47.51%
-33.95%


While the size of the global hedge fund industry declined by 34% after reaching its highest value in June 2008, the fund of funds universe contracted by almost 48% after touching its maximum. It must be noted here that more than 50% of the redemptions seen in hedge funds in 2008 were due to fund of funds – single-managers saw outflows of US$219 billion in 2008, with fund of funds accounting for US$116 billion. This has continued through 2009, with fund of funds accounting for more than 60% of the total redemptions seen in hedge funds (US$220 billion out of US$365 billion).

Figure 8 shows the change in assets under management for the hedge fund and fund of funds industries over the last two years.

Figure 8: Asset Flows to Hedge Funds and Funds of Funds



Although the hedge fund space has attracted capital for seven consecutive months since May 2009, the fund of funds sector continues to witness negative net asset flows. The recent financial scams – Madoff being the prime example – have had the effect of making investors very cautious when allocating to multi-managers. With concerns about exposure to fraudulent hedge funds, institutional and private investors now demand more transparency and communications from asset managers and are also directly investing in single-manager hedge funds as opposed to going through multi-managers.

Performance

Figure 9: Comparative Performance across Fund Types (Dec-05 to Oct-09)



The Eurekahedge Global Fund of Funds Index has returned to its pre-crisis levels and the industry is, as past performance dictates, on track for recovery. However, the index lagged behind the Eurekahedge Global Hedge Fund Index and the Eurekahedge Long-Only Absolute Return Fund Index. As seen in Figure 9, the Eurekahedge Global Hedge Fund Index has returned to its 2007 all-time high, rebounding strongly from its lowest point in November 2008. The Eurekahedge Long-Only Absolute Return Index, on the other hand, is about 13% higher than where it was in December 2005.

Looking at the performance from a drawdown perspective, funds of funds have, however, performed better than long-only absolute return funds. The maximum drawdown during the December 2005 to October 2009 period for the average fund of funds was about 19.89% while the drawdown for the Eurekahedge Long-Only Absolute Return Fund Index was about 48.90% – more than double that of fund of funds. On the other hand, hedge funds, as depicted by the Eurekahedge Global Hedge Fund Index, posted a 14.90% decline in the same period.

Also on the topic of drawdowns and taking reference from the performances of the three indices in Figure 9, the drawdown period for the average long-only absolute return fund and the average fund of funds was about the same – both indices peaked around October 2007 and bottomed around February 2009. Still, the average fund of funds fell less than the average long-only fund in this period. Individual hedge funds achieved a shorter drawdown period as the Eurekahedge Global Hedge Fund Index peaked around May 2008 and bottomed around November 2008.

Regions

Figure 10: 1-Year and 3-Year Returns across Geographical Mandates



Breaking down funds of hedge funds performance on a geographical basis, the best returns came from managers who invested in emerging markets funds. Emerging markets multi-managers have achieved 21.8% returns through 2009 as underlying single-managers had their best November YTD since 2003, gaining 31.2% on average. Multi-managers focusing on the region also came out on top in the longer term as emerging markets hedge funds have witnessed tremendous growth in recent years – the Eurekahedge Emerging Markets Hedge Fund Index has gained a massive 369% since its inception in December 1999.

At the other end of the spectrum are European funds of funds, which continue to remain in negative territory over the three years despite a positive performance in the last 12 months. Multi-managers investing in European hedge funds suffered the most during 2008 as the Eurekahedge European Fund of Funds Index shed 23.5% during the year. A significant number of London-based funds of funds (which was the biggest fund of funds centre during the pre-financial crisis) had invested in local hedge funds which were particularly hit by the collapse of Lehman Brothers, their exposure to the UK economy (which was one of the worst hit during the financial crisis) as well as to global equity markets. On average, 50% of London-based funds of funds closures in the June 2008 to July 2009 period were allocating more than 60% of their assets to long/short equity managers. Another major factor affecting the European fund of funds sector was the exposure of Swiss-based multi-managers to Bernard Madoff’s fraudulent fund, which left many of them struggling in terms of performance while also facing massive redemptions from panicked investors, forcing them to withdraw from successful strategies.

Strategies
Figure 11: 1-Year and 3-Year Returns across Strategic Mandates



Figure 11 shows the breakdown of performance by strategies over the last 12 months and three years. Except for distressed debt and arbitrage, all other strategic mandates have produced positive returns over the last 12 months.

Although most strategies have had a sound 2009, 3-year returns are still evenly split between positive and negative performers. Funds of funds solely investing in single-managers who employ fixed income strategies remain in negative territory on a 3-year basis as the underlying managers delivered sub-par returns in 2008 as well as in 2007. While the financial crisis adversely affected hedge fund performances across the board (with the exception of CTA funds), managers with exposure to the debt markets fared worse than the rest because of the credit crunch preceding the downturn.

Funds of funds investing in broad-focused strategies finished positive over both 1-year and 3-year periods. Allocations to hedge funds with net long exposure to commodities have benefited most managers over the last few years while a significant number of managers have also posted profits from their allocations to funds betting on currency movements. Funds investing in CTA and macro have also recorded the lowest volatility in their returns – both over the past year and 3-year periods – which can be attributed to the consistent returns provided by the underlying hedge funds.

Fund of Funds and Hedge Funds Performance

Figures 12a to 12e show the performance of hedge funds and the respective fund of funds in various regions. Although fund of funds performance strongly correlates with that of the underlying hedge funds, they have mostly underperformed the underlying regional hedge fund index (82% of the time). While the underperformance and an extra layer of fees are not very attractive for fund of funds investors, there are still some good aspects of investing in them, such as diversification and the enormous amount of time and resources spent in researching and allocating directly to single-managers.

Figure 12a–12e: Hedge Fund and Fund of Funds Performance






Figure 13 shows the volatility performance of hedge funds and fund of funds for the past nine years, taking the Eurekahedge Global Hedge Fund Index and Fund of Funds Index as references. Both indices have witnessed an increase in volatility in the past few years; however, fund of funds remain less volatile than hedge funds. In fact, the volatility of fund of funds was lower than hedge funds during 2001 to 2004 and more recently, in 2009. The record losses seen through 2008, which saw fund of funds down by 19.6%, had the effect of significantly increasing their volatility. However, with the lower standard deviation that funds of funds provide, they remain beneficial to an investor’s portfolio from a diversification perspective.

Figure 13: Fund of Funds Annualised Volatility



New Developments in the Fund of Funds Landscape

Multi-managers have started to take various measures to adapt to the new landscape; however, the effectiveness of these steps is yet to be seen. Most prominent among these steps is the change in performance fees. Table 3 gives the average performance fees of new launches in the 2005 to 2009 period.

Table 3: Average Performance Fees in Funds of Funds


2005
2006
2007
2008
2009
Performance Fees
10%
10%
10%
9%
6.5%


The added layer of management and performance fees imposed by funds of funds has been questioned widely, especially after their considerable underperformance vis-à-vis single-manager hedge funds in 2008. With an increasing number of investors choosing to allocate directly to hedge funds, multi-managers realise the need for better terms and conditions to stay attractive. However, the change has not translated into a significantly increased interest among investors as the sector continues to witness negative net asset flows.

In addition to changes in the fee structures, funds of funds have also taken steps to address transparency concerns of investors. An increasing number of multi-managers are now providing greater details of their investments in terms of allocations to region-specific hedge funds as well as the strategies of the underlying hedge funds. Additionally, multi-managers are also addressing investor concerns about redemption frequency by allowing investors greater accessibility to their cash. However, they will always remain a step behind hedge funds in this regard as they will have to account for an additional layer of redemption periods of the underlying hedge funds.

Furthermore, fund of funds managers are expecting increased regulations for the industry, which could have a significant impact on their strategic investment decisions and assets raising ability. In anticipation of this, many managers, particularly in Europe, have already started preparing for a changed landscape by exploring the new UCITS framework as well as allocating to hedge funds that are already under the UCITS III umbrella (currently, Eurekahedge is tracking 300 funds offering the UCITS structure). While providing greater transparency, structure, frequency of reporting and liquidity, this development also allows managers to explore new capital raising opportunities from institutional European investors such as pension funds.

While there is more regulation to be expected for fund managers in the West, Asia is seeing more funds of funds and hedge funds launches. Competitive cost structures in Asian hedge fund centres, as well as a host of service providers, are resulting in more startups in Asia. Furthermore, high net worth individuals in Asia have been increasing as the region undergoes rapid growth and a greater number of multi-managers are looking to tap into the new potential client base.

Conclusion

Funds of funds continue to go through challenging times, both in terms of performance as well as in capital raising. The sector has largely underperformed the single-manager space in 2009 while also facing record withdrawals. Some of the underperformance can be attributed to the forced selling of positions due to redemption pressures; however, going forward, multi-managers need to more closely mirror the performance of the underlying hedge funds and provide greater downside protection if they are to reverse the two-year trend of negative asset flows. Furthermore, fund of funds managers will also need to incorporate more stringent due diligence practices of prospective hedge funds so as to avoid the possibility of exposure to fraudulent funds like those seen in the recent past, which took a massive toll on investor confidence.

That said, the sector has responded to the challenges by addressing investor concerns and the measures being taken have started to attract new capital. The size of negative flows has decreased as the year progressed and the third quarter actually saw two months of positive net flows (although they were quite modest). We believe that the fund of funds industry will gradually shift into the positive territory in terms of net flows during the first half of 2010 as the managers continue to provide value (expertise in different strategies as well as saving time and effort) to investors seeking exposure to hedge funds.