Monday, May 31, 2010

2010 Key Trends in Funds of Hedge Funds

Introduction

Based on data in the Eurekahedge database, we estimate the current size of the fund of hedge funds sector to be US$435.7 billion in assets, with 3,124 funds. The current assets under management represent a 17-fold increase in the size of the industry over the last decade although the sector witnessed considerable losses towards the end of 2008 and early 2009.

The robust growth in the funds of hedge funds in the 2000–2007 period was fuelled mainly by the increasing interest in hedge funds among investors, such as pension funds, endowments, trusts and financial institutions. These investors turned to multi-managers for their expertise in fund selection and asset allocation while also seeking to diversify away from traditional equity and mutual fund investments. Furthermore, funds of funds helped investors maintain geographically diversified portfolios without having to personally conduct extensive due diligences on single managers and also to benefit from consistent returns and downside protection.

Over the last 18 months, the global fund of hedge funds universe has gone through what can be called a watershed period for the industry. While the end of 2008 and the start of 2009, marked by widespread redemptions and performance-based losses, was quite brutal for  managers, the latter part of 2009 through early 2010 has been a period of consolidation for the industry.

Figure 1 illustrates the growth (assets and number of funds) of the industry since 2000.

Figure 1: Industry Growth over the Years


The assets under management declined to a low of US$433 billion in April 2009 before stabilising around the end of the year. While managers started posting positive returns after the first quarter of 2009, the gains were evened out due to net negative flows which continued through most of the year. The following section discusses the asset flows in the sector in greater detail.


Industry Make-Up and Growth Trends

The following pages will look at the fund of hedge funds sector in terms of recent asset flows and the changes in the make-up of the industry in terms of regional investment mandate and strategies employed.

Asset Flows

Table 1 shows the monthly asset flows across the fund of hedge funds industry since the start of 2008. While the risk aversion triggered by harsh movements across some key asset classes and the credit crunch preceding the global financial crisis had already started to manifest in the form of redemptions through 2Q2008, the fall of some major financial institutions along with major financial scams, such as the Madoff scandal, led to massive withdrawals by investors in 4Q2008 and 1Q2009. Furthermore, even though performance was back on track after March 2009, the redemption pressure continued until July 2009 before easing out in the last five months of the year.

Although 1Q2010 has seen net negative asset flows, we believe that the consistent performance by multi-managers since March 2009 will translate into net subscriptions going forward, albeit on a smaller scale than the previous years, as investors look for consistent returns, such as those delivered by the multi-managers in the last 12 months, particularly from funds of funds that navigated the 2008 downturn with the lowest drawdowns.

Table 1: Monthly Asset Flow in Funds of Hedge Funds

Month
Net Growth (Performance)
Net Flows
Assets at end
Jan-08
-13.6
22.7
817.8
Feb-08
6.7
-9.9
814.7
Mar-08
-12.2
23.7
826.2
Apr-08
4.0
-9.3
820.8
May-08
8.7
-6.4
823.2
Jun-08
-5.5
1.9
819.6
Jul-08
-12.3
-4.3
803.0
Aug-08
-7.1
-6.3
789.5
Sep-08
-34.2
-44.7
710.7
Oct-08
-28.5
-29.1
653.1
Nov-08
-9.6
-14.0
629.5
Dec-08
-9.9
-40.6
578.9
2008
-113.5
-116.3
578.9


Month
Net Growth (Performance)
Net Flows
Assets at end
Jan-09
2.9
-72.2
509.7
Feb-09
-0.7
-32.2
476.8
Mar-09
-0.5
-8.7
467.6
Apr-09
0.7
-14.6
453.7
May-09
10.0
-16.3
447.3
Jun-09
1.3
-6.2
442.5
Jul-09
4.5
-13.4
433.7
Aug-09
3.2
1.5
438.4
Sep-09
7.1
1.0
446.5
Oct-09
-0.1
-5.3
441.2
Nov-09
3.3
3.6
448.1
Dec-09
2.0
-4.9
445.2
2009
-33.8
-167.6
445.2
Jan-10
-0.6
-12.4
432.2
Feb-10
0.5
-1.3
431.4
Mar-10
5.3
-0.8
435.9


Figure 2: Displaced Moving Average of Net Flows vs Eurekahedge Fund of Hedge Funds Index


Historical monthly asset flow figures in the fund of funds sector show a strong correlation between a month’s negative performance and net redemptions in the following one or two months and vice versa. Figure 2 displays this trend since December 2006, showing the moving average of net flows displaced by two months against the Eurekahedge Fund of Hedge Funds Index. However, the positive flows witnessed in the latter half of 2009 have not been strong enough to bring the average in positive territory despite a marked improvement in performance. This is due to the fact that investors have shied away from multi-managers due to a variety of reasons, including notable relative underperformance in 2008, lapses in due diligence procedures, which exposed them to frauds, and the gated redemptions wherein investors could not access their assets during the 4Q2008 and 1Q2009 period. Furthermore, investors have been allocating capital directly into hedge funds, potentially banking on an increasing number of third-party hedge fund marketers and independent advisors for fund selection and due diligence processes. As shown in Figure 3, the assets growth rebound has been much greater in hedge funds as opposed to funds of hedge funds.

Figure 3: Comparative Growth of Funds of Funds and Hedge Funds Assets under Management


Geographical Mandates

Figures 4a-4c: Fund of Hedge Funds Breakdown of Industry Assets by Regional Allocations

  




The fund of hedge funds industry has shown some notable trends over the last five years in terms of the changes in the regional allocations of assets under management. While North American hedge funds continue to attract the greatest capital from the multi-managers, their share of the pie has reduced from 55% to 51% in the last five years. The high level of investment in North American funds can be explained, first of all, by the fact that the hedge fund universe itself is dominated by North American managers – making up more than 50% of the funds and holding 65% of the assets. In addition, North American hedge fund firms are considerably older (and hence more experienced) with longer track records and established reputations, thereby attracting significantly more attention from the multi-managers.

The other significant trend observed over the last few years is the flow of assets towards broader mandated funds, ie hedge funds investing globally or in emerging markets. The most significant change observed is the 8% increase in the assets-invested global hedge funds and this is mainly due to their lower volatility and the diversification they bring to a portfolio. Emerging market funds have also seen their share of fund of hedge fund allocations increase, nearly doubling since 2006, as they provide the investors with exposure to growth markets. However, we have observed a reduction in allocations to single-country hedge funds, with multi-managers choosing funds that are well diversified within the emerging markets sector.

Strategic Mandates

Figures 5a-5c: Fund of Hedge Fund Population by Strategic Mandate by Assets under Management

 




The fund of hedge funds universe is well-diversified in terms of allocations to hedge funds with different strategic mandates, with none of the strategies holding a substantially large portion of assets. While the distribution of assets has not changed dramatically as one would expect after a significant upheaval in the industry, there have been some key observations which point to a more robust asset allocation approach. One of the biggest change observed is the decrease in the share of event driven funds which, although contrary to what one would expect given the strong performance of underlying funds, addresses the liquidity issues that multi-managers faced during the height of the financial crisis, as event driven funds tend to rather illiquid. This offers further evidence that funds of hedge funds have actively adopted measures to address their investors’ demands.

Another major trend has been the decrease in the allocations to macro funds and a concurrent increase in the share of multi-strategy funds. This is attributed to the flexibility offered by multi-strategy funds through the credit crunch, the financial crisis and the subsequent recovery, as the underlying managers could trade across asset classes and employ various strategies available to them. Furthermore, multi-strategy funds offered managers the fund of funds diversification of investments across different asset classes as a measure of managing their risks amid market uncertainties.

Fees

Table 2: Average Fund of Hedge Fund Fees by Launch Year

Year
Average Management Fees (%) of Launches
Average Performance Fees (%) of Launches
2005
1.39
10.16
2006
1.32
10.03
2007
1.30
9.38
2008
1.40
8.92
2009
1.37
7.00


During 2009, the average performance fee of new funds of hedge funds launches dropped to 7%, suggesting that multi-managers have been willing to further lower their cut to become more competitive, attract more capital and pass greater profits to their investors. This also shows the continuance of the trend seen in 2008, when the average performance fees among start-ups declined against the backdrop of growing criticism, continued redemptions and demand from investors to alter their fee structures.

The management fee structure, however, has not changed much over the years as the average management fees since 2005 through 2009 are still within the fund industry standard of 1-2%. The performance fees, as an additional layer to the usual fees charged by traditional funds, now also include fees for increased due diligence and risk management requirements (which investors are willing to bear) as well as increased research and scrutiny of single manager background, qualifications and past track record. As such, the decrease in the performance fees, coupled with an increase in the services rendered by multi-managers, shows the commitment in the fund of funds industry to meet the enhanced requirements of their investors. 

Performance Review

The fund of hedge funds industry has delivered consistent positive risk-adjusted returns over the last decade. The performance has mostly been at par with investor requirements, with the exception of 2008 when multi-managers, like everyone else, suffered due to the sharp downturn in global markets, extraordinary redemption pressure leading to forced liquidations and from exposure to some fraudulent funds. However, despite all these challenges, funds of hedge funds outperformed the global markets, long-only funds and conventional mutual funds significantly, losing 19.79% through 2008 – a year which saw most markets shedding 40%-60%. Furthermore, despite witnessing continued redemptions in 2009, multi-managers delivered healthy 9.70% returns for the year. More significant are the long-term gains and stability in returns offered by funds of funds, which is what most of their investors look for when allocating their capital. Since its inception in December 1999, the Eurekahedge Fund of Funds Index has gained 69.79% as compared with a 15.65% loss for the MSCI World Index.

Regions

Fund of funds across all regional mandates have delivered positive results over the last 12 months which can be considered in terms of 2009 returns and 1Q2010 returns.

Figure 6: Performance of Fund of Hedge Funds across Regional Mandates


Japanese funds of hedge funds delivered the best returns in 1Q2010, registering 2.96% as the underlying funds posted strong profits on the back of higher Japanese asset prices. 1Q2010 also saw consistent positive performances by North American fund managers, with the Eurekahedge North American Fund of Funds Index gaining 2.31%, making it the fourth consecutive positive quarter for the regional mandate and making it the 13th month of back-to-back gains.

Multi-managers adopting an emerging markets approach to their regional allocations continue to witness excellent returns, with their 12-month returns standing at 24.32%. Underlying emerging markets single managers have profited considerably from the excellent recovery in developing economies which has outpaced global markets through 2009.

North American funds of funds were the best regional performers in 2009, with the Eurekahedge North American Fund of Funds Index witnessing its best annual returns on record of 14.78% as the underlying single managers also realised their highest annual returns on record. Asia Pacific funds of funds made healthy gains in 2009, outperforming the average multi-manager by 3.21%.

Table 3: Performance of Fund of Hedge Funds across Regional Mandates

EH Asia Pacific Fund of Funds Index
EH Emerging Markets Fund of Funds Index
EH Europe Fund of Funds Index
EH Global Fund of Funds Index
EH Japan Fund of Funds Index
EH North America Fund of Funds Index
12-Month Returns
13.77%
24.32%
11.73%
9.03%
8.74%
15.67%
5-Year Annualised Returns
4.42%
9.64%
2.35%
2.45%
1.01%
3.96%
5-Year Annualised Standard Deviation
8.16%
9.59%
7.81%
6.24%
6.38%
6.47%
Sharpe Ratio
(5 Years)
0.05
0.59
-0.21
-0.25
-0.47
-0.01
Maximum Drawdown (5 Years)
-25.80%
-23.98%
-25.33%
-20.02%
-18.74%
-20.36%



When considering the regional mandates over a longer time period, we find that until mid-2007, European managers had been among the best performers; however, in 2008, they experienced greater losses than their regional counterparts, partly due to their exposure to some fraudulent funds which further led to heavy redemptions by panicked investors. The high volume of withdrawals contributed to their underperformance as funds of funds were forced to liquidate potentially profitable positions. The sector saw a performance drawdown of 25.3% through the credit crunch and the financial crisis before posting a recovery in February 2009 and gaining 12.21%.

Strategies

Figure 7: Performance of Fund of Hedge Funds across Strategic Mandates


Most strategies remain positive in the 12-month rolling returns figure, with consistent performances through most of 2009 and 1Q2010. Event driven and long/short equity funds of funds stood out as the best performers  in the last 12 months, returning 16.3% and 13.6%, respectively. Multi-managers invested in event driven hedge funds profited from an excellent year for the underlying managers, who benefited from the increased corporate activity in capital markets and various opportunities in 2009, posting the best annual returns on record across all broad hedge fund strategies.

1Q2010 was an excellent quarter for fixed income multi-managers as they outperformed all other fund of funds strategies as well as the average underlying fixed income hedge fund. The Eurekahedge Fixed Income Fund of Funds Index beat the Eurekahedge Fixed Income Hedge Fund Index by 26 basis points, suggesting that multi-managers are currently invested in the top performing hedge funds in the bond sector.      


Table 4: Performance of Fund of Hedge Funds across Strategic Mandates

EH Arbitrage Fund of Funds Index
EH CTA Fund of Funds Index
EH Distressed Debt Fund of Funds Index
EH Event Driven Fund of Funds Index
EH Fixed Income Fund of Funds Index
EH Long / Short Equities Fund of Funds Index
EH Macro Fund of Funds Index
EH Multi-Strategy Fund of Funds Index
EH Relative Value Fund of Funds Index
12-Month Returns
6.54%
-1.15%
13.10%
16.31%
11.56%
13.58%
4.51%
10.74%
12.40%
5-Year Annualised Returns
1.04%
5.60%
2.17%
2.63%
1.70%
3.07%
6.30%
2.90%
1.69%
5-Year Annualised Standard Deviation
3.76%
8.29%
4.96%
5.03%
3.99%
6.93%
4.93%
5.01%
5.36%
Sharpe Ratio
(5 Years)
-0.79
0.19
-0.37
-0.27
-0.58
-0.13
0.47
-0.22
-0.43


Fund of Funds and Hedge Funds Performance

Figures 8a-8e show the performance of hedge funds and the respective fund of funds in various regions. Although funds of funds performance strongly correlates with that of the underlying hedge funds, they have mostly underperformed the underlying regional hedge fund index.

Figures 8a – 8e: Hedge Fund and Fund of Funds Performance



Volatility

Funds of hedge funds seek to diversify away the manager-specific risk by distributing capital to a variety of strategies. By investing in a wide array of hedge funds, multi-managers deliver lower volatility and consistent returns.

Figure 9 shows the 5-year rolling annualised volatility of funds of funds, hedge funds, long-only absolute return funds and global equity markets.

Figure 9: Rolling Annualised Volatility of Alternative Instruments in the Past 4 Years


While funds of hedge funds did not match the returns from other alternative investment vehicles last year, they have, however, been the least volatile. The 5-year annualised standard deviation of the funds of hedge funds is 0.3% lower than that of hedge funds and nearly 9% lower than that of long-only absolute return funds. When compared with underlying markets, this difference becomes even greater, with the volatility of funds of funds less than one-third that of global equity markets (represented by the MSCI World Index). Furthermore, the Eurekahedge Fund of Funds Index had annualised 5-year returns of 10.9%, which was much higher than the MSCI World Index performance of -3.31%.


Table 3: Comparative Performance of Alternative Investments vs MSCI World

EH Fund of Funds Index
EH Hedge Fund Index
EH
Long-Only Absolute Return Fund Index
MSCI World Index
12-Month Returns
11.02%
20.95%
59.47%
49.09%
5-Year Annualised Returns
10.90%
23.88%
18.42%
-3.31%
5-Year Annualised Standard Deviation
5.15%
5.48%
14.11%
16.46%
Sharpe Ratio (5 Years)
1.34
3.62
1.02
-0.44

In Closing

The fund of hedge funds industry has gone through some very challenging times in the last few years. Performance-based losses in 2008 and massive withdrawals in the last two years reduced the size of the industry by almost 50%. Multi-managers have, however, raised their game to meet the challenges by delivering consistent risk-adjusted returns over the last four quarters. Furthermore, they have started to take various steps to address the concerns of investors, such as improving fee structures and their due diligence processes, and adding greater diversity to their assets.

While the sector has continued to see net outflows, the size of the redemptions has decreased over the months and going forward, we expect the industry to start attracting greater capital from 2Q2010 as investors look for stable returns amid volatile market conditions. We expect funds of hedge funds to keep delivering consistent risk-adjusted performance through the rest of the year and the size of the industry to reach US$500 billion by December 2010.