The global fund of hedge funds industry has gone through turbulent times over the last four years. After growing at an incremental pace from 2003 to mid-2008, the industry was hit with excessive losses and widespread redemptions during the financial crisis. Since then, multi-managers have struggled to attract a significant amount of assets.
Figure 1: Industry growth since 2000
| ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
Asset flows
Figure 2: Comparative asset flows in fund of hedge funds and hedge fund AuM since January 2008
Figure 2 compares the growth of assets in funds of hedge funds and hedge funds since January 2008. Although assets in both industries are still below their respective levels at the start of 2008, the growth trends are remarkably different. The greater growth of hedge funds is attributed to the better returns posted by – and strong asset flows to – single managers over the last two and a half years.
Launches and closures
The funds of hedge funds population has been declining over the last four years as shown in Figure 3. While the number of funds grew exponentially between 2003 and 2007 to reach a maximum of 3,574 as seen in Figure 1, the attrition rate increased in 2008 and has continued to exceed the launch rate through to 3Q 2011. Currently, the global fund of hedge funds population stands at 3,326 funds.
Figure 3: Launches and closures of funds of hedge funds since 4Q 2008
Fees
As a response to the changes in the investment landscape post-2008, funds of hedge funds have implemented various measures to address investor demands. In terms of fee structures, the average multi-manager has moved to reduce performance fees over the last few years. Before the financial crisis, the average performance fee of funds of hedge funds was around 10.5%. Since then this average has dropped into single digits. Table 2 shows the average performance and management fees charged by funds of hedge funds since 2005.
Table 1: Average funds of hedge funds fees by launch year
Source: Eurekahedge
Redemption notice
In addition to the fee structure, funds of hedge funds have also taken steps to address other investor concerns.
Table 2: Average redemption notice period by launch year
Source: Eurekahedge
The average redemption notice period increased steadily until 2007 and averaged around two months, however this number dropped to a little more than one month in 2010 and 2011. One of the major concerns among the investors has been the redemption frequency of funds of hedge funds – in 2008, a number of managers had put up gates and suspended redemptions which left investors unable to pull their capital from falling markets. Due to this, a number of investors started allocating directly to hedge funds as they offered better liquidity terms. In order to remain attractive, funds of hedge funds have moved to address this concern, resulting in great redemption frequency.
Head office location
The distribution of funds of hedge funds by head office location in 2006 and 2011 is shown in figures 4a-4b. The breakdown of fund population has witnessed significant changes over the last five years. The US continues to be home to the largest number of managers given that the region has the most number of funds of hedge funds investors, as well as the most number of hedge funds to invest in. However, its share of the population has decreased over the years from 28.1% to 25.4%, while the share of European funds has increased with the UK and Switzerland now accounting for more than 40% of the industry.
Figures 4a-4b: Head office location by number of funds
 
Figure 5 shows the breakdown of funds of hedge funds launches by head office location over the last few years. The increasing number of launches in European centres such as the UK and Switzerland, as opposed to the United States, show that these places have witnessed stronger growth in terms of fund population. This trend is partially explained by the strong growth in UCITS III compliant funds of hedge funds.
Figure 5: Office locations of launches by number of funds since 2006
Geographic mandates
The observations from the breakdown of funds of hedge funds office location are also applicable to the distribution of geographic investment mandates with the share of assets allocated to North American hedge funds decreasing from 46% to 37%, while the share of assets in globally investing hedge funds has witnessed an increase of 8%. In addition to the general trend towards diversification, global-mandated hedge funds also protected capital allocated to them in 2008, losing a modest 2.7% in the year where most single-region mandates turned in double-digit losses. This outperformance led to further allocations to global funds in 2009 and 2010, as they were perceived as safer vehicles in times of high volatility as these funds provided the most downturn protection through the financial crisis.
Figures 6a-6b: Manager allocation by geographic mandates
Strategic mandates
In terms of AuMs allocated to different strategic mandates, macro funds lost the most share over the last five years, declining from 19% to 14% of total industry assets. The loss in capital is mostly attributed due to investor redemptions and reallocation to other newer strategies. Bucking this trend, CTA/managed futures funds gained more market share due to the excellent performance of underlying managers during the financial crisis and the subsequent healthy asset flows. Event driven hedge funds have lost half of their share; unsurprising since the strategy tends to be rather illiquid and thus, not very compatible with the trend towards greater liquidity in the fund of hedge funds industry.
Figures 7a-7b: Manager allocation by strategic mandates
Performance review
Over the last 11 to 12 years, funds of hedge funds have delivered significant outperformance to the underlying markets in terms of returns and drawdown. The Eurekahedge Funds of Funds Index registered an annualised return of 4.62% since December 1999, while the MSCI World Index has an annualised return of -1.36%. In the medium term, over the last 5 years (as of end August 2011), funds of hedge funds achieved a 0.93% annualised return while underlying markets have lost 2.80% on an annualised basis. The maximum drawdown for funds of hedge funds was 20.16% (October 2007 to December 2008) which is lower than the 52.60% drawdown as recorded by the MSCI World Index (October 2007 to February 2009).
When compared to hedge funds however, funds of hedge funds have not matched the excellent performance posted by single manager funds. Although funds of hedge funds have not delivered results comparable to hedge funds, they have provided greater stability of returns. The annualised volatility of funds of hedge funds since 1999 was 5.06%; lower than the 5.47% figure of hedge funds and much lower than 15.67% for the MSCI World Index.
Figures 8: Performance of funds of hedge funds, underlying markets and hedge funds since December 1999
Figure 9: Annualised volatility of various instruments over the years
Table 3: Performance of funds of hedge funds vs. other investment vehicles
Source: Eurekahedge
Table 4 and figure 10 highlight the returns of funds of hedge funds against other investment vehicles over the last 12 months, five years and 10 years. While funds of hedge funds have underperformed hedge funds, they have outperformed the markets in the medium and long terms. Additionally, funds of hedge funds have witnessed the lowest volatility of returns among all the investment classes. This suggests that funds of hedge funds investments should appeal to long term investors as they have offered better returns with lower risk. Furthermore, these returns show that a portfolio of hedge funds will add value to investors through better risk adjusted returns in the short, medium and long terms. This evidence is further supported by the risk-return profile of the new Mizuho-Eurekahedge suite of indices, which show that a passively managed portfolio of hedge funds can generate excellent returns for investors. For information on the various statistical properties of the Mizuho-Eurekahedge customisable indices please download the Mizuho Eurekahedge Indices Analysis Report[1].
Figure 10: Performance of funds of hedge funds vs. other investment vehicles
Geographic mandates
In terms of geographic investment mandates, all geographic allocations delivered positive returns for the last 12 months, with funds of hedge funds allocating to North American hedge funds edging ahead of the rest. The multi-managers who invested in large North American hedge funds delivered the largest gain over the last 12 months – large North American hedge funds locked in a 12 month return of 15.22%.
Funds of hedge funds allocating to emerging market hedge funds posted the best returns over the last ten years, with profits of 11.43% on an annualised basis. This comes on the back of strong returns seen in emerging market hedge funds; the Eurekahedge Emerging Market Hedge Fund Index delivered an excellent annualised return rate of 15.69%. These long term returns also show that emerging market funds of hedge funds were able to effectively capture the gains posted by the underlying single managers.
Table 4: Performance of geographic mandates
Source: Eurekahedge
Figure 11: Performance of geographic mandates
Strategic mandates
As shown in table 6 and figure 12, allocations to macro hedge funds performed the best over the one, five and 10 year time frames (with annualised returns of 5.55%, 5.24% and 6.32% respectively) despite recording a 2.55% loss in 2008. Comparatively, the Eurekahedge Macro Hedge Fund Index posted respective annualised returns of 4.49%, 5.96% and 9.78% in the same periods. Even more impressive is the fact that the average return of macro funds of hedge funds surpassed the returns of macro hedge funds in the last 12 months, despite incorporating an extra layer of fees. In terms of maximum drawdown in the last five years, managers allocating to CTA hedge funds had the lowest drawdown of 7.77%. Underlying CTA hedge funds in the last five years returned 10.32% on an annualised basis and locked in an annualised standard deviation of 6.79%.
Table 5: Performance across strategic mandates
Source: Eurekahedge
Figure 12: Performance across strategic mandates
 |
[1] The Mizuho Eurekahedge Indices Analysis Report can be found online at http://www.eurekahedge.com/indices/mei_analysis_hedge_fund_report_nov_11a.asp
