2010 Key Trends in Asian Hedge Funds

Introduction

The Asian hedge fund space, which includes funds that are either based in Asia or investing in Asia, has been one of the fastest growing sectors in the global hedge fund industry since 2000, both in terms of assets and number of funds. However, the industry has also gone through difficult periods and diverse phases. After witnessing tremendous growth in the first eight years of the decade, Asian hedge funds went through a lean period in 2008 and early 2009 amid the global financial downturn and widespread redemptions. However, the industry rebounded in 2H2009, posting excellent returns and attracting more capital – the Eurekahedge Asian Hedge Fund Index was up 26.79% in 2009, the strongest yearly return on record for the index.

Figure 1 shows the growth of the Asian hedge fund industry since 1999.

Figure 1: Growth of the Asian Hedge Fund Industry

After posting some spectacular results in 2009, Asian hedge funds have witnessed mixed returns and subdued subscriptions in the first seven months of 2010[1]. While the last year ended on a high note with excellent performance and strong asset flows, a spike in risk aversion and volatility in global markets during the first half of 2010 translated into marginally negative performance (July YTD) and weak asset flows. As of July 2010, the size of the Asian hedge fund industry stands at US$116.9 billion, which is more or less the same since the start of the year.

Industry Make-Up and Growth Trends

Asset Flows

The first seven months of 2010 have yielded slightly negative asset flows of US$1.2 billion from the Asian hedge fund space as investor confidence has been low through most of the year. Concerns over the European debt contagion spreading to emerging markets and Asia have also had a negative effect on market sentiment while fears of a double-dip recession have not subsided. In this environment, managers have found it hard to raise capital for their funds while investors have been cautious about the volatile markets, choosing to hold their allocations on the whole. However, if markets stabilise into an upward trend for the rest of the year, we anticipate greater inflows to the sector with Q4 expected to witness the strongest assets flows this year.

Table 1a shows asset flows and performance-based growth in Asian hedge funds since the start of 2008. Table 1b shows the growth in Asian hedge fund launches in 2009 and 2010 through asset flows.

Table 1a: Asset flows across Asian Hedge Funds (US$ billion)

Month	Net Growth (Perf)	Net Flows	Assets at end
2008	(26.0)	(23.6)	126.4
Jan-09	0.1	(9.1)	117.4
Feb-09	(0.2)	(4.7)	112.5
Mar-09	0.6	(4.6)	108.5
Apr-09	1.3	(5.1)	104.8
May-09	3.6	(2.6)	105.8
Jun-09	0.4	(0.2)	106.0
Jul-09	1.6	0.5	108.1
Aug-09	(0.2)	1.7	109.7
Sep-09	1.0	1.2	112.0
Oct-09	(0.0)	2.8	114.7
Nov-09	0.9	1.0	116.7
Dec-09	0.9	(0.1)	117.4
2009	10.1	(19.1)	117.4
Jan-10	(1.2)	(0.6)	115.7
Feb-10	(0.2)	(0.7)	114.8
Mar-10	2.2	(0.1)	116.9
Apr-10	0.9	(0.4)	117.4
May-10	(2.4)	0.7	115.6
Jun-10	(0.3)	(0.2)	115.1
Jul-10	0.8	0.4	116.2

Note: All figures are in US$ billion.

Source: Eurekahedge

Table 1b: Asset Flows across Asian Hedge Funds (US$ billion)

Average AuM Growth in Asian Hedge Fund Launches through Asset Flows
Year	Total Growth	Growth per Month
2009	81%	6.75%
2010	33%	4.71%

The Asian hedge fund sector witnessed strong asset flows in the last six months of 2009, gaining US$7.2 billion through net subscriptions amid rising market sentiment. Comparatively, assets in Asian funds of hedge funds have remained low and have not seen any growth after losing nearly 60% of their total assets during the global financial crisis after reaching a peak of US$87.8 billion in December 2007.

Figure 2 shows the relative growth in Asian hedge funds and Asian funds of hedge funds over the last two years and a half.

Figure 2: Relative Growth of Asian Hedge Funds and Funds of Funds

Table 1 (on the previous page) demonstrates an interesting correlation between one month's negative performance and the net redemptions of the following one or two months and vice versa. Figure 3 shows the monthly net flows displaced by three months plotted against the Eurekahedge Hedge Fund Index. This seems to suggest that investors have subscribed two to three months after periods of positive performance and redeemed two months after periods of negative performance at corresponding magnitudes to the underlying performance. Whether this truly suggests that investors are 'trend-following' or a simple statistical manipulation is open to some debate.

Figure 3: Displaced Net Flows vs Eurekahedge Asian Hedge Fund Index

Another interesting perspective is the high proportion of assets allocated to larger funds as opposed to medium-sized and small funds. Table 2 shows that in 2010, the largest 20% of funds manage nearly 80% of Asian hedge fund assets, an increase of more than 7% over the last six years. The biggest jump of nearly 2% occurred in 2008 when a significant number of smaller funds were forced to close due to losses and heavy redemptions. Larger funds, on the other hand, were able to handle the crisis better given their larger asset base.

Table 2: Proportion of Assets in Large Asian Hedge Funds

Percentage of Asian Hedge Fund Assets in the Largest 20% of the Funds
Year	% of Assets
2005	72.8
2006	74.0
2007	76.1
2008	78.9
2009	79.2
2010	79.8

Fund Population

The first half of 2010 has seen launch activity picking up in the Asian hedge fund space, with the total number of hedge funds now standing at 1,278, exceeding the previous maximum of 1,240 seen in 2007. The 125 Asian hedge fund launches in the first seven months of the year represent a return to the healthy growth seen before 2008. The strong launch activity witnessed so far in 2010 is a result of growing interest in Asia due to greater growth potential in the regional economies as well as developments in the regional hedge fund service provider industry, making it easier for managers to set up their funds in the region. Other factors include increasing availability of complex financial products in the Asian markets, lower set-up costs as compared with the West, desire for large hedge fund investing institutions to diversify into Asia and efforts from Asian governments to attract global managers.

Figure 4: Asian Hedge Fund Launches and Closures

Lifecycle of Asian Hedge Funds

This section explores the trends in the average ages of hedge funds and statistically looks into whether there is any truth behind the common myth that the average lifespan of a hedge fund is 4 to 5 years.

Figure 5: Historical Lifespan of Asian Hedge Funds

Figure 5 shows the population of live and dead hedge funds according to their age as at 30 August 2010. We include dead funds in this analysis to counter the survivorship bias which would be inherent if this distribution was based entirely on live funds. The age-wise population of hedge funds demonstrates leptokurtic properties or positive skewness, showing that while most of the hedge funds are concentrated around the median age of 3.7 years, there are outlier funds that have been around for a long time and hence, increasing the mean age to 4.6 years.

Table 3 shows that the average life of dead funds[2] is increasing over the years. This suggests that managers are increasingly able to develop successful strategies and hence, last longer by earning performance fees while also raising enough capital in the early years to hit their survival threshold.

Table 3: Average Life of Dead Funds over the Years

Year of Liquidation	Average Life (Years)
2002	2
2003	2.6
2004	2.6
2005	2.6
2006	3.6
2007	3.4
2008	3.6
2009	4.3
2010	4.7
Average	3.3

Fund Sizes

Figures 6a-6c: Breakdown of Asian Hedge Funds by Fund Sizes

The breakdown of the Asian hedge fund sector according to different fund size tranches shows some significant changes in the composition of the industry over the last few years. These changes are reflective of the growth in the Asian hedge fund space both in terms of asset flows and performance-based gains.

Figures 6a-6c show the composition of the Asian hedge fund sector by fund size in July 2004, July 2008 and July 2010. The industry, though still young, was in a phase of rapid growth in 2004 – and this phase continued until mid-2008. During this time, the number of small hedge funds with US$20 million or below fell by 7% as most of the small funds grew significantly through healthy asset flows and strong performance-based gains. At the same time, Figures 6a-6c show that there were more than 800 funds launched during this period and since Asian funds tend to start relatively small, it can be deduced that most of the funds in mid-2008 with assets less than US$20 million were new start-ups while those funds that had started earlier grew in size and got 'promoted' into the next fund-size category.

Since July 2008, however, as the credit crunch and the subsequent financial crisis took its toll on hedge fund assets, the industry composition has changed back to its pre-2005 days. In fact, currently, the number of relatively smaller hedge funds, managing US$50 million or less, has increased to 66% of the Asian sector.

Geographical Mandates

The composition of the Asian hedge fund sector in terms of the geographic mandates of the managers has also witnessed significant changes over the years amid the growth of funds and development of the regional industry.

Figures 7a-7c: Changes in the Geographic Mix of Asian Hedge Funds

by Assets under Management

While some trends were reversed after the global financial crisis, the trend towards greater geographical diversification has continued through July 2010. In July 2004, global-mandated funds made up 15.7% of the sector – this number has now expanded to 17.1%. This is primarily due to two reasons: a) funds with a broader geographical mandate did not suffer as much as regional or single-country funds during the global financial crisis and b) most global-investing funds have significantly increased their allocations to Asia in the recent years due to the strong growth in the regional markets and continued growth potential.

On the other hand, Japan-mandated funds have lost nearly 70% of their share of the Asian hedge fund universe in the last six years. This can be attributed to the exceptional growth in Asia ex-Japan hedge funds and three consecutive years of negative returns (2006, 2007 and 2008) by Japanese funds which led to investors allocating greater capital to the growth regions.

Strategic Mandates

Figures 8a-8c: Changes in the Strategic Mix of Asian Hedge Funds

In terms of strategies, the Asian hedge fund sector has witnessed some strong movements over the last six years, as shown in Figures 8a-8c. The most important trend has been the decrease in the share of long/short equity funds from 60% of the sector to 44%. However, this is not a sudden change in the aftermath of the global financial crisis; instead, this is a sustained trend through the years which can be attributed to the increasing availability of other strategies in the regional hedge fund space, greater access and easing of restriction in markets such as China and India, and the availability of more complex financial instruments in Asian markets.

Head Office Location and Fund Domicile

Figures 9a-9b: Head Office Location by Number of Funds

In terms of hedge office locations of Asian hedge funds, the United Kingdom continues to hold the top spot as the share of US-based funds decreased. The trend suggests that a significant number of the older Asian hedge funds were set up in the US initially since the Asian hedge fund centres were not fully developed in terms of an investor base as well as service providers and financially trained workforce.

Within Asia, Hong Kong continues to be the dominant hedge fund centre while Singapore also gained some ground. Although Hong Kong did lose some of its market share as the global economy went through the financial downturn, it still accounts for more than 250 hedge funds as it was among the first in Asia to boast a wide-range of hedge fund service providers and investors, making it an attractive location for managers to set up shop in.

Figure 10: Fund Domiciles by Number of Funds

In terms of fund domiciles of Asian hedge funds, the Cayman Islands still rule the roost, with 59% of the managers choosing the location to set up their hedge funds. Cayman offers friendly regulation as well as ease of fund set-up, featuring a large number of service providers, such as law firms, accounting firms, and administrators – and with tougher regulations being introduced in the US and Europe, we expect an increase in the number of Cayman-domiciled funds.

Fee Structure

Table 4: Asian Hedge Fund Fees

Year	Performance Fees (%)	Management Fees (%)
2000	19.48	1.49
2001	19.75	1.47
2002	19.82	1.54
2003	18.61	1.47
2004	19.75	1.58
2005	19.42	1.73
2006	18.78	1.62
2007	19.08	1.84
2008	18.86	1.68
2009	17.94	1.66
2010	19.22	1.56

Table 4 shows the changes in the fee structures of Asian hedge fund launches over the last decade and although management fees have remained similar, performance fees witnessed a decrease in 2008 and 2009 as the managers responded to calls from investors to lower their performance fees. However, the average performance fees in 2010 Asian hedge fund launches are back above 19% amid a recovery in the sector.

Service Providers

This section looks at the service provider industry in Asian hedge funds – it must be noted here that this analysis is based on data reported by hedge funds to the Eurekahedge database on a biannual basis.

Prime Brokers

Table 5: Prime Brokers – AuM Share of Asia-Focused Hedge Funds

2007 Prime Broker Share Morgan Stanley 26.62% Goldman Sachs 26.49% UBS 9.15% Bear Stearns 9.13% Deutsche Bank 7.50% Credit Suisse 6.60% Merrill Lynch 3.77% Citigroup 3.23% Fimat 0.53% Man Financial 0.09% Others 6.89%

2010 Prime Broker Share Morgan Stanley 23.9% Goldman Sachs 21.6% JP Morgan 16.9% Credit Suisse 9.00% UBS 8.40% Deutsche Bank 7.90% Citibank 3.40% Bank of America Merrill Lynch 3.30% Barclays 1.50% Newedge 1.40% Others 2.60%

Table 5 shows the top 10 prime brokers by hedge fund assets. The changes observed in the Asian hedge fund prime broker industry suggest a move towards greater diversity versus three years ago. Before the collapse of some large financial institutions, two prime brokers accounted for more than 50% of Asian hedge fund assets; however, currently the space has more equitable distribution among the large institutions. It should be mentioned here that before the financial crisis, it was the prime brokers that had put in measures for counter-party risk; however, since then, fund managers have also become wary of their dependence on prime brokers and have diversified their businesses across the different service providers. Furthermore, the share of 'Other' has also decreased, suggesting that managers prefer working with well-known and financially stable prime brokers.

Table 6 shows the share of prime brokers among the top performing (1^st quartile) hedge funds, going by 2010 performance.

Table 6: Prime Brokers' Share of Top Performing Asian Hedge Funds (1^st Quartile)

Prime Broker	Share
Goldman Sachs	13.5%
Deutsche Bank	12.9%
Morgan Stanley	10.7%
Citi	10.7%
Credit Suisse	10.7%
UBS	9.0%
Bank of America Merrill Lynch	3.9%
Newedge	2.8%
JP Morgan	2.8%
BNP Paribas	2.2%
Others	20.8%

Administrators

As with prime brokers, the trend among the hedge fund administrators has also moved towards greater diversification. The most noteworthy trend is a drop in the share of assets administered by 'Others', which includes in-house administration. The primary reason for this shift is the emphasis on regulations and transparency - no investor is ready to invest with managers who do not have the proper risk controls in place and reputed third-party administrators.

Table 7: Hedge Fund Administrators – AuM Share of Asia-Focused Hedge Funds

2007 Admin Share HSBC 32.17% CITCO 10.76% State Street 4.94% Citigroup 4.11% Goldman Sachs 3.36% PNC 2.91% JP Morgan 2.40% Morgan Stanley 2.03% Fortis 1.98% Northern Trust 1.95% Others 33.39%

2010 Admin Share HSBC 22.30% State Street 20.30% CITCO 11.90% BNP Paribas Fortis 4.11% IFCE 2.90% Daiwa 2.80% Viteos 2.50% Citigroup 2.50% SS&C 2.50% Admiral 2.20% Others 21.50%

 

 

Performance Review

Asian hedge funds have outperformed underlying Asian stocks significantly since 2000 as shown in Figure 11. The Eurekahedge Asian Hedge Fund Index gained 157% since inception while the MSCI Asia Pacific Stock Index lost 6% over the same period.

Figure 11: Performance of Asian Hedge Funds and Equities in the Last 10 Years

Figure 12: Performance of Asian Hedge Funds and Other Investments over 5 Years

Hedge funds have consistently outperformed underlying markets over time, but there were distinct periods at which hedge funds delivered significantly better results. For example, Asian stock markets experienced a drawdown of 53% during the 2000-2003 period while Asian hedge funds were up 48% during the same time. Additionally, during the 2008 economic slowdown, hedge funds lost 25% of their NAVs on average while Asian stocks plummeted by 56% (MSCI Asia Pacific Index). This highlights the resilience of the Asian hedge fund industry during economic downturns and why they can be important additions to investor portfolios. Asian hedge funds have also performed better than other alternative investment classes in the region such as funds of hedge funds and long-only absolute return funds as shown in Figure 12.

Figure 13 highlights the superior risk management capabilities of Asian hedge fund managers. The average annualised standard deviation of the Eurekahedge Hedge Fund Index is 6.8%, much lower than the 16.6% for Asian equities. Managers kept portfolio volatility to less than 15% on average while the comparative figure for the underlying markets is 37% in April last year.

As such, not only have Asian hedge funds outperformed the underlying markets in the long and medium terms, they have done so with lower volatility, delivering consistent risk-adjusted returns as per their mandate.

Figure 13: 12-Month Rolling Standard Deviations of Asian Hedge Funds and Equities

Geographical Mandates

Figure 14: Performance of Asian Hedge Funds across Geographic Mandates

Looking at the performance by regional mandates, India-focused hedge funds are the top performers in 2010 as well as over the last 12 months. The Eurekahedge India Hedge Fund Index returned 4.45% July YTD (which is 2.1% more than the Indian SENSEX Index) and delivered gains of 16.4% since July 2009. Most of the Indian hedge funds are long/short equities as shown in the graph. The managers have not only been able to capture the upside in the markets, they have also protected capital through the volatility of 2010.

The other two regional mandates that performed positively this year are Korea- and Japan-focused funds, which have achieved healthy returns of 2.3% and 1.6%, respectively, (July YTD). Japanese long/short equity managers, who form the bulk of the Eurekahedge Japan Hedge Fund Index, have performed especially well this year, beating the benchmark Nikkei 225 Index by 11.1%.

Over the longer time period, Greater China hedge funds dominate the landscape. Their stellar performances in 2007 (up 55.7%) and 2009 (up 45%) compensated for the 25.9% loss in 2008 and also for the subdued returns this year. Overall, managers investing in Greater China have performed exceptionally well over the past decade. Excellent growth and strong economic fundamentals have created an extra depth of liquidity in the region, giving hedge fund managers more opportunities to profit using various trading styles. The Eurekahedge Greater China Hedge Fund Index has gained a massive 736% since its inception.  

Table 8: Performance across Asian Geographic Mandates

	EH Asian Hedge Fund Index	EH Australia / New Zealand Hedge Fund Index	EH Greater China Hedge Fund Index	EH India Hedge Fund Index	EH Japan Hedge Fund Index	EH Korea Hedge Fund Index
12-Month Returns	5.04%	13.57%	4.62%	16.43%	1.10%	4.76%
3-Year Annualised Returns	0.82%	2.67%	4.52%	0.32%	-2.20%	-4.46%
3-Year Annualised Standard Deviation	10.95%	11.86%	16.34%	26.14%	7.52%	12.26%
2010 YTD Returns	-0.74%	-3.56%	-3.08%	4.45%	1.61%	2.28%
2009 Returns	26.71%	41.52%	45.31%	53.62%	7.17%	9.47%

Strategic Mandates

Figure 15: Asian Hedge Fund Performance (Strategies)

Most strategic mandates across the Asian hedge fund space have witnessed broad gains in 2010 July YTD. Managers deploying trades in the fixed income space are the best performers so far in the year, with distressed debt hedge funds leading the way. In the first seven months of 2010, the Eurekahedge Asia Distressed Debt Hedge Fund Index has gained 6.15% – which is twice as much as what the same group of hedge funds returned for the whole of 2009 – primarily due to a positive outlook on emerging market debt. Distressed debt investing is also the most profitable hedge fund strategy worldwide in 2010 and investors have injected more capital into distressed debt hedge funds than any other strategy.

Asian fixed income hedge funds have also fared well in 2010 – the Eurekahedge Asian Fixed Income Hedge Fund Index is up 4.6% this year. Top performing fixed income themes have been those focused on high-yielding issues while the funds utilising leverage to amplify their gains have also delivered excellent returns. Comparing the returns of fixed income hedge funds across the globe, Asia ex-Japan fixed income hedge funds are the top performers with double-digit YTD gains of 11.3%.

Long/short equity is the only negative Asian strategy in 2010, primarily due to the unpredictable volatility seen in the underlying equity markets. Since long/short equity managers form the bulk of Asian hedge funds on an equally weighted basis, their negative returns have also pulled the overall sector performance into the red. However, hedge funds have still outperformed the underlying markets in the year – the Eurekahedge Asian Hedge Fund Index is down 0.43% as opposed to a -1.12% loss in the MSCI Asia Pacific Index (July YTD).

Table 9: Performance across Asian Strategic Mandates

	EH Asia  Arbitrage Hedge Fund Index	EH Asia  CTA Hedge Fund Index	EH Asia Distressed Debt Hedge Fund Index	EH Asia Event Driven Hedge Fund Index	EH Asia Fixed Income Hedge Fund Index	EH Asia Long/Short Equities Hedge Fund Index	EH Asia Macro Hedge Fund Index	EH Asia Multi-Strategy Hedge Fund Index
12-Month Returns	4.17%	4.36%	11.57%	9.66%	11.97%	4.15%	4.81%	3.96%
3-Year AnnualisedReturns	3.48%	13.21%	1.43%	4.74%	5.15%	-0.29%	4.05%	1.53%
3-Year Annualised Standard Deviation	5.69%	6.18%	4.60%	8.93%	8.19%	11.83%	5.12%	8.74%
2010 YTD Returns	0.98%	0.23%	6.15%	3.89%	4.56%	-1.97%	1.52%	-0.20%
2009 Returns	14.68%	18.40%	3.06%	24.05%	21.45%	27.88%	14.25%	19.86%

Overview of 2010 Key Trends in UCITS III Hedge Funds

Introduction

The phenomenal growth in UCITS III hedge funds[1] over the last few years has been one of the most interesting developments in the global alternative investment sector. Currently, the Eurekahedge UCITS III Hedge Fund Database lists 775[2] UCITS III products, with another 500 to be added in the coming months. Furthermore, the Eurekahedge UCITS Hedge Fund Index, the industry benchmark and most widely used tracker in the sector, consolidates the monthly performance of 236 funds.

Utilising data from the Eurekahedge UCITS Hedge Fund Database, this report picks up from our introductory piece in March 2010 and analyses the key trends emerging from the UCITS III hedge fund sector over the last few years. For a more detailed introduction on the unique features of UCITS III regulations and fund structure, please refer to our previous report[3].

Figure 1 shows the growth in UCITS III hedge funds in the last three years.

Figure 1: Industry Growth over the Years

The size of the global UCITS III hedge fund industry currently stands at US$131 billion, managed by 615 unique[4] (flagship) funds. Given the rapidly changing dynamics of the industry, we predict this number to continue growing at a rapid pace. An important point to note here is that most of the growth in the UCITS III fund industry comes not from new boutique fund start-ups but from the following three segments:

a)    UCITS III funds launched by existing hedge fund management companies. In the post-financial crisis environment where issues of regulations, transparency and liquidity have taken centre stage, existing hedge fund managers have identified the UCITS structure as a key to raising assets. Additionally, the UCITS passport further helps in providing access to retail investors, a previously untapped source of capital for hedge funds.

b)    Hedge fund products launched by existing mutual fund management companies. The widespread losses suffered by mutual funds in 2008 and early 2009 brought their performance in sharp contrast to that of hedge funds. As such, mutual fund companies are increasingly looking to capitalise on the flexibility in investment approach afforded by the UCITS III regulation where they can also employ downside protection measures.

c)     The growth in UCITS III funds is further compounded by a significant number of existing 'regular' hedge fund managers who make wholesale shifts to the UCITS structure. Such funds tend to have an existing investment approach that is very close to the UCITS requirements (mostly by initial design) and as such, these funds are then treated as UCITS funds since inception.

Figures 2a-2b: Growth of UCITS Hedge Funds Relative to Global Hedge Funds

Geographical Investment Mandate

Figures 3a-3b: Changes in the Geographic Mix of UCITS III Funds

Since UCITS is a European regulation, it comes as no surprise that the largest share of investments on a regional basis goes to Europe. Also, UCITS III managers are located primarily in Europe and most managers tend to invest in the regions that they are based in.

However, there has been a trend of increasing diversity in the geographic focus of investments. While the share of Europe-focused funds has decreased from 47% to 43%, global-mandated funds have increased their share of the pie. Nevertheless, the small share of North America-dedicated funds is counter-intuitive as the region is home to the largest market with the most number of hedge fund investment products. This is primarily because European funds that invest in North America do so as part of the global mandate. In fact, nearly 90% of the global-focused funds include North America (or USA) in their investment mandates.

While the share of Asia ex-Japan funds has remained unchanged at 11%, it is important to note that this forms a substantial share of the asset allocations of European funds. The region has witnessed the greatest growth in recent times and since many European investors are keen to gain exposure to emerging markets, we expect their share to increase over time.

Domiciles

Figures 4a-4b: Domicile by Number of Funds

As per UCITS regulation, all UCITS funds are required to be domiciled onshore in a member state of the European Union. While traditional European hedge funds are primarily domiciled in offshore centres like the Cayman Islands, the largest onshore hedge fund domiciles are Luxembourg and Ireland, together accounting to 75% of the industry. These two locations are preferred over other EU nations because they possess the necessary infrastructure to service UCITS funds (ie, large number of service providers) as well as having more friendly tax regulations.

Between the two locations, though Luxembourg still accounts for 50% of the fund domiciles, Ireland has managed to increase its share by 6% over the last three years. Currently, the two centres hold distinct advantages over each other: while it is much more economical to set up in Ireland (Irish regulators require fund promoters to have a minimum capital of €0.64 million, whereas the requirement in Luxembourg is in the region of €7.5 million); the service provider industry in Luxembourg is better suited to administer high volumes of transactions on a daily basis which is a key benefit since a number of hedge fund managers are launching UCITS products to target the retail investor market segment.

Head Office Location

Figures 5a-5b: Head Office Location by Number of Funds

In terms of head office locations, Europe continues to account for nearly 90% of UCITS III hedge funds. This is primarily because a) UCITS is an EU regulation, hence, it is easier for European funds to subscribe and b) most UCITS III investors are European and it is easier to market the fund if the manager is based in Europe.

The United Kingdom dominates the manager location breakdown of UCITS hedge funds, accounting for nearly half of the fund population. While the population of UCITS funds was more widely distributed previously because of its pan-European base, the share of UK-based UCITS funds has increased by 12% in the last three years, primarily because of the strong launch activity witnessed in the last two years. For new managers who are considering launching a UCITS III fund, the location offers access to large pool of hedge fund and fund of funds investors. UK investors are also familiar with the UCITS framework and are a ready source of start-up capital for the newly regulated hedge funds. Additionally, London also boasts a wide range of service providers and administrators as well as top talent and infrastructure, making it a one-stop shop for managers looking to set up a fund.

Furthermore, being one of the most important financial service centres in the world, the country is already home to a large number of alternative investment management companies (43% of all European hedge funds are based in the UK) and as such, it is the natural location for UCITS III-compliant vehicles offered by existing companies.

Strategic Mandates

Figures 6a-6b: Changes in the Strategic Mix of UCITS III Funds by Number of Funds

In terms of strategic mandates, the structure of UCITS III hedge funds has witnessed some considerable changes. While there is now greater diversity in the sector in terms of asset classes and strategies employed, the major change has been the shift from long-only absolute return strategies towards long/short equity mandate. The primary reason for this is, again, the exceptionally strong launch activity in the sector over the last two years, especially by hedge fund management companies (that have been looking to raise assets from investors who have increasingly demanded regulated products). Furthermore, nearly 50% of the funds launched in 2009 and 2010 employ the long/short equity mandate for the following reasons:

a)    Long/short equity forms the largest share of global hedge fund strategies (31%); hence, the proportion of existing hedge fund management company launching UCITS funds would naturally be in favour of this strategy.

b)    It is relatively easier for long/short equity managers (and of course, long-only absolute return funds) to operate under the UCITS umbrella.

c)     As opposed to complex strategies, long/short equity is more intuitive and easily marketed to retail investors who may not be as sophisticated as traditional hedge fund investors

Additionally, there are also a handful of long-only absolute return funds that have modified their strategy to take advantage of the shorting ability available under the UCITS framework, hence, effectively becoming long/short equity funds.

Performance Review

This section compares the performance of UCITS III hedge funds against other comparative investment vehicles and the relative performance of different strategic mandates within the UCITS hedge fund sector over the last five years.

Figure 7 shows how UCITS III hedge funds have performed versus hedge funds, funds of hedge funds and the MSCI World Index.

Figure 7: Performance of UCITS III Hedge Funds vs Other Investments

When compared with the underlying equity markets, UCITS III hedge funds have not only provided better downside protection but also have managed to capture most of the upside, hence, providing greater returns over the longer term with less volatility than investing directly in the markets (through traditional mutual funds, unit trusts, ETFs and suchlike).

Hedge funds, on the other hand, have outperformed UCITS III hedge funds – while the UCITS III funds have gained about 20% over the last five years, hedge funds have delivered nearly twice the returns. The reasons for this include high leverage employed by unregulated hedge funds to boost their profits and strong returns generated by event driven and distressed debt strategies, which have very little representation in the UCITS III space. However, with an increasing number of hedge fund managers launching their own UCITS funds, we expect the performance numbers to compare more favourably in the future and in the shorter term. In fact, as shown in Figure 7, the returns of UCITS III hedge funds have been closer to those of hedge funds over the last 12 months.

Figure 8: Performance of UCITS III Hedge Funds vs Other Investments

UCITS III hedge fund returns also show that these regulated products tend to fall at the midpoint of hedge fund and fund of funds performances. When compared with funds of hedge funds, there are two main factors which benefited UCITS III managers in the last two to three years. First, in 2008, they had greater flexibility to close on positions that they are holding and were able to quickly liquidate them as the markets started to tumble while funds of funds were left exposed to various illiquid hedge funds with gated redemptions. Secondly, in 2009, funds of funds witnessed redemptions through most of the year, hence, being forced to redeem their capital out of underlying hedge funds that were witnessing a record year in terms of performance. UCITS III managers, on the other hand, saw strong interest in their funds from investors.

Table 1 shows the statistics of the different investment vehicles considered in this analysis.

Table 1: 3-Year Performance of Alternative UCITS III Hedge Funds and Equities

(From July 2007 to July 2010)

	Eurekahedge UCITS Hedge Fund Index	MSCI World Index	Eurekahedge Fund of Funds Index	Eurekahedge Hedge Fund Index
12-Month Returns	7.17%	7.66%	3.00%	7.59%
3-Year Annualised Returns	-0.72%	-10.44%	-3.69%	3.99%
3-Year Annualised Standard Deviation	10.18%	23.00%	7.14%	7.35%

Figure 9 compares UCITS III fund performance with that of mutual funds[5] over the last three years. Some of the reasons for the differences observed below are:

a)    Unlike hedge funds, mutual funds have investment objectives which restrict their allocation of assets. This affects their performance to a large extent, which partly explains why they tend to underperform UCITS III hedge funds.

b)    As a result of performance-enhancing techniques such as leveraging, UCITS III hedge funds have delivered better returns than mutual funds for three out of the four years shown in Figure 9, the exception being 2009 when the strong rallies in underlying markets delivered exceptional gains to mutual funds.

c)     Furthermore, the ability of UCITS III hedge funds to employ synthetic shorts has greatly helped them to outperform mutual funds in time of economic downturns. For example, in 2008, UCITS III hedge funds delivered returns of -14.72% at a time when mutual funds were down 35% on average and the underlying markets lost up to 60%.

In the last three years, UCITS III hedge funds have outperformed mutual funds by more than 15%, which is a reflection of their main investment philosophy – UCITS III hedge funds are absolute return vehicles and are supposedly mandated to protect capital in all market conditions while mutual funds tend to track their respective benchmark indices.

Figure 9: UCITS III Hedge Funds vs Mutual Funds

Strategies

Table 2: Performance across Strategies

	Long-Only	Arbitrage	CTA / Managed Futures	Event Driven	Fixed Income	Long/ Short Equities	Macro	Multi-Strategy
12-Month Returns	3.00%	1.31%	4.52%	3.25%	4.59%	4.09%	3.54%	2.71%
3-Year Annualised Returns	-3.69%	3.12%	2.43%	2.01%	3.19%	1.48%	4.78%	2.54%
3-Year Annualised Volatility	7.14%	1.72%	4.67%	2.39%	2.72%	7.38%	4.07%	6.53%

Figure 10: Performance across Strategies

UCITS III hedge funds have witnessed positive results across all strategies over the last 12 months. Fixed income UCITS III hedge funds advanced 4.6% as low interest rates nurtured a favourable environment for fixed income hedge funds. Within the sector, hedge fund managers who focused on high yielding debt saw the biggest gains. Over the three-year timeframe, fixed income hedge funds delivered annualised gains of 3.2%, outperforming the average UCITS III hedge funds by nearly 4% every year.

UCITS III CTA/managed futures hedge funds have been the best performing in 2010 while macro funds show the highest three-year annualised returns as they were able to capture the upside in trending markets in 2009 while also delivering positive returns in 2008.

Fees

Table 3: Fee Structure of Global Hedge Fund and UCITS III Hedge Fund Launches

	Global Hedge Funds		UCITS III Hedge Funds
Year	Average Performance Fee (%)	Average Management Fee (%)	Average Performance Fee (%)	Average Management Fee (%)
2007	19.32	1.74	12.42	1.20
2008	18.84	1.65	14.51	1.33
2009	17.61	1.64	16.88	1.44
July 2010	18.46	1.54	17.73	1.35

Table 3 shows the changes in the fee structures of global hedge funds and UCITS III hedge funds over the last three years. While the average management fees of both sectors remain low and at par with most mutual funds, the performance fees have shown some significant movements. The performance fees of hedge funds launched after 2008 dropped below 19% as managers found it increasingly hard to raise capital from sceptical investors. On the other hand, UCITS III hedge funds have consistently raised their fees over the last few years, primarily because of two reasons. First, the funds have seen increasing interest from hedge fund investors who are used to paying performance fees and have been drawn to the sector because of the regulated structure of the funds; hence, the managers can raise their fees without much fear of losing the incremental inflows. Secondly, an increasing number of hedge fund management companies that have traditionally operated in the 2/20 structure have launched their UCITS III products while replicating the fee structure of their traditional hedge funds.

      

In Closing

The UCITS III hedge fund sector has witnessed phenomenal growth over the last few years. The call for more transparency and regulation for hedge funds has seen a large number of UCITS III hedge fund launches in recent years – the number of UCITS III hedge funds has grown by 200% since 2007 and assets under management have increased 170% over the same period. The outlook for the UCITS III hedge fund industry looks promising as we expect to see more capital inflows not only from traditional hedge fund investors but also from retail investors while the number of launches in the space continues at an exponential pace.

By the end of 2010, we expect the size of the industry to exceed US$150 billion, with the number of funds figure closing in on the 1,000-mark. With incremental interest in UCITS III hedge funds and the fast pace of developments, we will be providing regular updates on the sector in our reports going forward. Watch this space in the coming months for more analyses including:

a)    UCITS vs European hedge funds

b)    Service provider landscape of UCITS funds

c)     First movers and trendsetters in the UCITS III hedge fund sector

d)    New start-ups vs new UCITS products by existing managers

e)    Investor analysis of UCITS funds

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[1] In this report, we include funds employing absolute return strategies with a hedge fund-like structure.

[2] As of August 2010.

[3] Overview of 2009 Key Trends in UCITS III Hedge Funds report by Eurekahedge published in March 2010.

[4] As opposed to multiple share classes, currency denominations and suchlike.

[5] The Bespoke Mutual Fund Index tracks the performance of unit trusts with a global-focused investment mandate and mutual funds that invests in both equities and bonds.