Introduction
The Eurekahedge North American Hedge Fund Index was up 13.33%[1] during 2010 as the region’s hedge funds maintained their winning run. North American managers had posted record returns in 2009, and although 2010 was marked by high volatility and sudden swings in the markets, North American hedge funds continued to deliver consistent returns throughout the year. This was the third consecutive year that the region’s hedge funds outperformed those in other developed markets. Managers also attracted significant capital from investors in 2010, gaining US$60.4 billion in net positive asset flows, accounting for most of the US$70.6 billion allocated within the global industry during 2010.
The total size of the sector now stands at US$1.08 trillion[2], managed by 4,576 hedge funds. These numbers represent a significant rally after the industry suffered massive redemptions and significant performance-based losses in 2008 and early 2009, when assets under management fell to US$849.2 billion. Excellent performance-based gains and positive net flows in the last three quarters of 2009 set the stage for the consolidation witnessed in 2010. Figure 1 shows the growth in the number of hedge funds and the assets under management in North American hedge funds since 2000.
From here on in, this report shall focus on data collected up to the end of November 2010.
Figure 1a: North American hedge fund industry growth over the years
Figure 1b tracks the assets under management in North American hedge funds since January 2009. The sector has witnessed a remarkable recovery since April 2009 and the overall upward trajectory has been quite consistent considering the on-again off-again nature of investor sentiment over the last 18 months. The gains were delivered not only through asset flows but also through performance as the average fund outperformed the underlying markets.
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Figure 1b: AuM growth in recent months
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Industry Make-Up and Growth Trends
The following pages discuss asset flows in the North American hedge fund industry in greater detail while also looking at the changes in the industry over the years in terms of fund population, strategies employed, geographical mandates and manager locations.
Asset Flows
After witnessing two years of net negative asset flows, North American hedge funds attracted significant inflows in 2010. The sector gained US$57 billion through net subscriptions alone (year-to-date November) and witnessed 10 straight months of positive asset flows. This accounts for a major part of the total asset flows into global hedge funds (86%) and is proportionally greater than the 67% share of North American hedge fund assets in the overall global industry.
These gains were not only a result of excellent performance in 2009 and the significant downturn protection delivered by North American managers in 2008 but also due to various measures undertaken by managers to placate investor concerns. A number of hedge funds addressed issues such as counter-party risk by diversifying their prime broker relationships, engaged reputable third-party administrators, increased their redemption frequency (hence, allowing investors greater access to their money), allowed for greater transparency and put in proper risk management structures. The changes undertaken by managers, coupled with the new regulatory regime, had the effect of rebuilding investor confidence in the asset class and resulting in the hefty asset flows witnessed by North American hedge funds.
Table 1 shows the monthly changes in assets under management due to net flows and performance in North American hedge funds.
Table 1: Monthly asset flows across North American hedge funds
Month
|
Net Growth (Performance)
|
Net Flows
|
Assets at end
|
Jan-09
|
6.7
|
(63.2)
|
918.6
|
Feb-09
|
(3.1)
|
(12.6)
|
902.8
|
Mar-09
|
(1.2)
|
(25.6)
|
876.1
|
Apr-09
|
7.5
|
(34.4)
|
849.2
|
May-09
|
22.6
|
1.1
|
872.9
|
Jun-09
|
(0.0)
|
7.2
|
880.1
|
Jul-09
|
13.4
|
(0.4)
|
893.1
|
Aug-09
|
7.9
|
10.9
|
911.9
|
Sep-09
|
16.7
|
13.3
|
941.9
|
Oct-09
|
0.5
|
5.1
|
947.5
|
Nov-09
|
11.1
|
4.5
|
963.1
|
Dec-09
|
6.4
|
(6.6)
|
962.9
|
2009
|
88.5
|
(100.7)
|
962.9
|
Jan-10
|
(1.3)
|
(2.6)
|
959.0
|
Feb-10
|
3.2
|
17.5
|
979.6
|
Mar-10
|
16.2
|
0.3
|
996.2
|
Apr-10
|
10.1
|
1.5
|
1007.8
|
May-10
|
(18.2)
|
6.5
|
996.1
|
Jun-10
|
(1.5)
|
1.3
|
995.9
|
Jul-10
|
8.4
|
1.7
|
1006.0
|
Aug-10
|
7.5
|
15.0
|
1028.5
|
Sep-10
|
22.9
|
4.9
|
1056.3
|
Oct-10
|
19.1
|
6.6
|
1082.0
|
Nov-10
|
(1.3)
|
4.3
|
1085.0
|
Source: Eurekahedge
Figure 2: Eurekahedge North American Hedge Fund Index vs 3-month moving average
net flows displaced by 1 month
Over the past few years, we have noted a strong correlation between a month’s negative performance and net redemptions in the following one or two months and vice versa. Figure 2 illustrates this trend since August 2008, with the moving average of asset flows displaced by one month against the Eurekahedge North American Hedge Fund Index. The negative net flows corresponding to the dips in the index (September 2008 - March 2009) clearly demonstrate this trend; however, whether this is simply a statistical manipulation or truly suggests that investors are 'trend-following' is open to some debate.
Figure 3: Monthly asset flows to North American hedge funds vs North American funds of hedge funds
Figure 3 compares the monthly asset flows to North American hedge funds and funds of hedge funds since the start of 2008. Although the trend of redemptions from hedge funds turned in 2Q2009, funds of hedge funds continued to witness net negative flows until July 2009. Since that period, they have not seen any significant subscriptions. Since 2008, a significant number of fund of hedge funds investors have started allocating directly to hedge funds and we attribute this to the better downturn protection provided by single-manager funds, their continued outperformance over the last three years and to the losses suffered by funds of hedge funds in 2008.
Investors were heavily let down
by the fund of hedge funds industry in 2008 because they performed so poorly vis-à-vis the hedge fund industry – the Eurekahedge Funds of Funds Index was down 19.35% in 2008 as opposed to a fall of 10.83% in the Eurekahedge Hedge Fund Index. One of the arguments for investing in funds of hedge funds was that while they may not capture all of the upside that a bucket of hedge funds might, they would certainly offer more downside protection during bad years; however, that was not the case in 2008. Investors would argue that it is acceptable to underperform during rising markets but you have to outperform during falling markets to be able to add value. This essentially makes paying the extra level of fees to invest in funds of hedge funds that much harder to justify from an investor’s point of view. When we take this in context, along with the Madoff scandal, the financial crisis and the general lack of capital to invest, the fund of hedge funds industry has taken a big blow that it has not recovered from. In addition, underperforming the average hedge fund again in 2009 by 10% did not help to strengthen investors’ appetite for this asset class. While some excellent fund of hedge funds managers remain in the industry, the business as a whole is still in the process of reinventing itself to start aggressively chasing assets again.
Funds by Size
Figure 4: Changes in the composition of the fund population by fund sizes
In terms of fund sizes, the North American hedge fund industry has witnessed some significant changes over the last few years. In the four years preceding the financial crisis, the proportion of smaller hedge funds, managing US$50 million or less, fell steadily until December 2008 – as shown by the blue and red bands in Figure 4. During these years, North American managers not only delivered substantial performance-based gains but also attracted significant capital from investors and therefore, were able to outgrow their initial AuM ranges.
Between December 2008 and December 2009, the proportion of smaller hedge funds (US$50 million or less) increased to account for 66% of the industry as managers suffered significant losses through the financial crisis and panicked investors withdrew large sums of capital. Since then, however, this number has fallen to 62% as regional managers posted excellent performance-based growth as well as attracted capital. However, most of the capital allocated to North American hedge funds has gone to the larger funds – the proportion of hedge funds managing US$200 million or more has increased from 10% of the industry in December 2009 to 14% in December 2010.
Some of the reasons for this trend are due to operational concerns such as risk control structures of smaller hedge funds (which might not be as robust and systematic as those of larger funds due to higher costs) and the inability of smaller hedge funds to afford the fees charged by larger prime brokers and administrators. (Although most managers of smaller hedge funds have made concerted efforts to address these issues since the financial crisis.) The main reasons for the preference among investors to choose larger funds include:
a) A predilection for established brand names and famous managers – although seemingly counter-intuitive since the Madoff fiasco, this remains a key decision factor among investors.
b) The sentiment that smaller hedge funds are more risky, which is primarily fuelled by a high attrition rate in 2008-2009 when a number of smaller hedge funds had to close due to heavy redemption pressure and the inability to earn any management fees.
c) Liquidity. If one investor’s capital forms a large part of the total fund AuM, then redemption by that investor will have an effect on the fund’s market positions and, hence, also affect other investors. As such, most investors have maintained minimum qualifying criteria of US$100 million for their hedge fund investments.
Geographical Mandates and Manager Location
In terms of geographical investment mandates, the North American hedge fund space (funds based in North America and exclusively investing into) is dominated by North America and globally investing hedge funds, which together account for 92% of the industry. It should, however, be noted that global-mandated hedge funds also invest a significant amount of their capital in North American markets (primarily in the US), and as such, the total hedge fund capital dedicated to the region is actually much higher than 38%. Additionally, although it seems like very little capital is allocated to emerging markets and to Asia, in reality, most North American investors looking to gain exposure to these markets go through global-mandated hedge funds.
The United States is the location of choice for 83% of North American hedge funds as it is the oldest hedge fund centre and also has the largest market. Additionally, most of the capital allocated to the hedge fund industry comes from the United States, and being the most developed hedge fund market with the greatest number of products, service providers and trained professionals, it is an obvious home for managers investing in North America. It should be noted that the share of the US had dropped to 77% in 2009 amid a high attrition rate; however, strong launch activity in 2010 has brought it back up above 80%.
Figure 5: Assets under management split by geographical mandate
Figure 6: Manager location by fund population
Strategic Mandates
Figures 7a-7b: Changes in the strategic mix of North American hedge funds by assets under management
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In terms of breakdown by strategic mandate, the North American hedge fund space has shown some significant trends over the last few years. The most prominent change is the reduction in the proportion of assets allocated to long/short equity funds. In December 2006, the long/short equity mandate accounted for 38% of the total assets in the North American hedge fund industry. By December 2010, however, this number has fallen to 30%. Reasons for this trend include the increasing availability and popularity of other hedge fund strategies, flight of capital to ‘safer’ asset classes during the credit crunch and the financial crisis, heavy redemptions and losses suffered by North American long/short equity managers during the financial crisis. It should be noted that the percentage of North American hedge fund assets in long/short equity funds had actually fallen below 30% in 2009 and remained so until the last quarter of 2010 – as shown in Figure 8. Excellent performance-based gains and strong positive net flows in 2010 have added to the assets managed by long/short equity funds and we expect managers to attract further capital from investors in 2011.
Figure 8: Quarterly changes in the strategic mix of North American hedge funds
by assets under management
The other major trend observed in the breakdown of strategic mandates over the last few years is the increase in the percentage of assets managed by broad-mandated funds. Multi-strategy funds, CTA/managed futures funds and macro-investing hedge funds have all increased in their proportion of North American hedge fund assets. This is attributed to a trend of diversification as these strategies invest in varied geographies as well as different asset classes. Additionally, CTAs and macro funds saw their share of the pie go up significantly throughout the financial crisis as they delivered positive performance at a time when all other strategies registered losses. Due to this performance, CTA and macro managers also received significant capital from investors in 2009, further adding to their gains.
Administrators
In the wake of the financial crisis, the heightened stress on regulations that hedge funds must adhere to has meant that they must employ recognised third-party administrators in order to attract any capital from investors. As such, the administrator landscape of the North American hedge fund industry, which is very competitive with a plethora of small players, has seen some consolidation within the top 10 firms – in 2008, the top 10 administrators accounted for just about 60% of industry assets while in 2010, the top 10 firms have more than 70% of industry assets under administration.
Tables 2a-2b: Top administrators by share of hedge fund assets
Source: Eurekahedge
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Prime Brokers
Tables 3a and 3b show the share of prime brokers in 2008 and 2010 based on data reported to the Eurekahedge databases by hedge funds themselves and not by prime brokers. While the top three prime brokers have remained the same, there has been a significant change in the make-up of the top 10 North American prime brokers. The share of ‘Others’ has also decreased to less than 10% as the industry has grown towards consolidation by larger financial institutions while managers have also started to avoid vulnerable banks. After the crash of two of the largest financial institutions, fund managers are now also wary of overdependence on single prime broker and there is an increasing trend of hedge funds subscribing to multiple prime brokers, bucking the earlier trend of depending on one institution only.
Tables 3a-3b: Top prime brokers by share of hedge fund assets
Source: Eurekahedge
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Fees
The fee structures of hedge funds also came under criticism during the financial crisis, prompting many new managers to offer reduced fees in order to attract greater capital from investors (as shown in Table 4). However, in 2010, the average performance fees of North American hedge fund launches is back above 19% as excellent performance in 2009 led to increased demand for hedge funds in 2010.
Table 4: Changes in fee structures of hedge fund launches between 2004 and 2010
Year
|
Average Performance Fees (%) of Launches
|
Average Management Fees (%) of Launches
|
2004
|
19.60
|
1.57
|
2005
|
19.92
|
1.69
|
2006
|
19.47
|
1.66
|
2007
|
20.35
|
1.63
|
2008
|
19.14
|
1.57
|
2009
|
17.45
|
1.67
|
2010
|
19.17
|
1.62
|
Source: Eurekahedge
Performance Review
The Eurekahedge North American Hedge Fund Index was up 9.80% in 2010 YTD November after delivering record returns of 23.60% in 2009. Over the years, North American hedge funds have delivered exceptional performance both in absolute terms, in comparison with other investment vehicles, and provided consistent risk adjusted returns to their investors.
Figure 9: Performance of North American hedge funds vs other investment vehicles
Table 5: Performance of North American hedge funds vs other alternative investment vehicles
Eurekahedge North American Hedge Fund Index
|
Eurekahedge North America Fund of Funds Index
|
Eurekahedge North America Absolute Return Fund Index
|
MSCI North American Index
|
Eurekahedge Hedge Fund Index
| |
12-Month Returns
|
11.75%
|
5.77%
|
16.89%
|
8.46%
|
8.87%
|
3-Year Annualised Returns
|
7.66%
|
-1.28%
|
1.49%
|
-6.58%
|
5.15%
|
3-Year Annualised Standard Deviation
|
7.52%
|
7.55%
|
17.87%
|
21.42%
|
7.17%
|
2010 YTD Returns
|
9.80%
|
4.44%
|
12.12%
|
6.40%
|
7.69%
|
Sources: Eurekahedge and MSCI
Figure 9 shows the performance of North American hedge funds against the three other investment vehicles and global hedge funds since November 2007 – the period that marked the start of the credit crunch which later developed into the financial crisis in 2008. Three years on the MSCI North American Index is still in negative territory, down by 18.48%. North American hedge funds, however, have weathered the downturn impressively with a three-year total return of 24.80%. The maximum drawdown for the Eurekahedge North American Hedge Fund Index in the last three years has been 12.19%, far lower than the 49.16% drawdown seen in the MSCI North American Index.
The Eurekahedge North American Hedge Fund Index is up 217.40% from December 1999 to November 2010, a period which witnessed the passing of two economic cycles. It was during the downturns that hedge funds provided the largest outperformance over the other investment vehicles. In the same period, the MSCI North American Index was down by 18.92% while North American long-only absolute return funds and North American funds of hedge funds gained 98.68% and 82.68%, respectively. Additionally, North American managers also outperformed global hedge funds which were up 209.62% on average since December 1999.
Geographical Mandates Performance
Figure 10: Performance by geographical mandate
Table 6: Performance by geographical mandate
Eurekahedge Global-Investing
North American Hedge Fund Index
|
Eurekahedge North America-Investing Hedge Fund Index
| |
12-Month Returns
|
8.10%
|
11.74%
|
3-Year Annualised Returns
|
6.01%
|
7.69%
|
3-Year Annualised Standard Deviation
|
6.33%
|
7.47%
|
YTD 2010 Returns
|
7.95%
|
9.80%
|
Source: Eurekahedge
The North American hedge fund sector can be split into two categories by geographic mandates – funds investing in North America and funds investing globally. After witnessing negative returns in 2008, funds of both mandates staged a strong comeback in 2009 and 2010, making up for the losses – North America-investing funds recorded three-year total returns of 24.90% while global-investing North American funds were up 19.12% over the same period. This also points to a trend of outperformance by North America-investing funds over those employing a global mandate (as shown in Table 6). This is primarily because a large sector of the global-investing North American hedge fund industry is made up of macro and CTA managers, whose recent performances have lagged behind their peers.
Another noteworthy point about North America-focused funds is the long-term performance of its CTA/managed futures hedge funds, which has been remarkable. According to the Eurekahedge database, North American CTA/managed futures managers have gained a massive 387.45% since December 1999. That is far better than the Eurekahedge CTA/Managed Futures Hedge Fund Index (which tracks the returns of CTA hedge funds worldwide) average of 255.55% over the same period.
Strategic Mandates Performance
Figure 11: Performance across strategic mandates
Table 7: Performance across strategic mandates in North American hedge funds
Arbitrage
|
CTA/ Managed Futures
|
Distressed
Debt
|
Event
Driven
|
Fixed
Income
|
Long/Short Equities
|
Macro
|
Multi-Strategy
|
Relative Value
| |
12-Month Returns
|
10.06%
|
7.24%
|
24.88%
|
19.23%
|
15.00%
|
11.31%
|
3.31%
|
9.92%
|
14.34%
|
3-Year Annualised Returns
|
9.03%
|
15.24%
|
8.30%
|
8.70%
|
8.01%
|
4.47%
|
9.63%
|
7.45%
|
8.75%
|
3-Year Annualised Standard Deviation
|
6.76%
|
7.73%
|
14.31%
|
14.08%
|
7.00%
|
9.98%
|
9.43%
|
6.43%
|
8.19%
|
YTD 2010 Returns
|
7.99%
|
7.62%
|
22.21%
|
14.39%
|
13.55%
|
8.84%
|
4.32%
|
8.53%
|
11.07%
|
Source: Eurekahedge
As illustrated in Table 7, North American hedge funds across all strategies have recorded outstanding returns in recent years as all sector indices registered net gains for all time periods under consideration. As a result of favourable market conditions and considerable skill of the managers, some Eurekahedge benchmark indices posted returns well above 15% in a short span of 12 months. Among the top performers in 2010 were distressed debt (22.21%), event driven (14.39%) and fixed income (13.55%) managers.
Distressed debt hedge funds emerged out of the crisis with exceptional gains – the Eurekahedge North American Distressed Debt Hedge Fund Index was up 64.42% in the past two years (22.21% in 2010). This was in sharp contrast to 2008, when the average distressed debt hedge fund was down 25.13% for the year due to poor credit market conditions and large client redemption requests. Liquidity has since improved and managers who bought distressed assets at the height of the financial crisis are reaping the rewards of their investment acumen.
North American event driven hedge funds registered a cumulative gain of 70.71% in two years, which makes event driven the best performing strategic mandate since the 2008 downturn. Managers capitalised on a flurry of corporate activity in the US leveraged loan market and in mergers and acquisitions. Leveraged loan issuances more than doubled in 2010 to US$369 billion from US$170 billion in 2009 as institutions refinanced their debts and LBO transactions increased.
North American fixed income hedge funds have also delivered excellent returns over the last two years, delivering gains of 44.81%. The managers achieved an annualised three-year return of 8.01%, with low interest rates keeping bond prices supported and boosting the bottom lines of portfolio managers. In 2009, investment performance of fixed income managers reached 28.24% while in 2010, the strategy has withstood a volatile market to end the 11 months of the year with a net 13.55% gain.
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