Alternative Investment Management Association
2007 turned out to be a tumultuous year, with the collapse of the US sub-prime mortgage market sparking the so-called “credit crunch” and repercussions across the world, ranging from the first bank run in the UK for well over 100 years, to many billions of dollars of debts being written off by other banks.
Not surprisingly, it turned out to be a year when there was a pronounced dispersion in the returns from hedge funds. There were some high-profile casualties, including some in the credit space, such as two structured credit funds written off with collective losses to investors of about $1.5 billion.
Also, feeling the heat were quantitative managers with an equity market neutral approach – with many seeing sharp, unprecedented falls in their value during the first half of August. While some rebounded quickly, the whole episode left many investors spooked – given that these had hitherto been generally low-volatility strategies – and seemed likely to provoke significant net redemptions from the quant area.
It was not until much later in the year that investors began to realise just how well many hedge funds had in fact performed in 2007. The investment banks may have lost billions in credit but this was not really the case for hedge funds overall. If anything, the opposite was true, with many hedge funds profiting from short positions on credit and financial stocks. Although average performance was lower than in 2005 and 2006, it was still well up – and comfortably ahead of the major equity market benchmarks in Europe and the US. In the US, the Absolute Return Composite rose 8.08 percent in 2007; the EuroHedge Composite rose 6.92 percent.
These raw median returns also disguised the fact that many bigger funds did considerably better than the medians last year – many profiting handsomely from strategies in Asia and emerging markets, commodities and directional plays in futures, as well as the financial sector.
Foremost among the big winners was a New York-based hedge fund group which dominated the annual Absolute Return awards event in December and were subsequently one of the first to foresee the impending collapse of the US sub-prime mortgage market and to identify the best risk-adjusted ways to play it. This resulted in huge gains and a massive increase in assets for the firm involved, from about $7 billion at the start of the year to around $29 billion by year-end.
To put this in its proper historical context, these were probably the most successful trades in the history of the industry, producing profits many times those of George Soros when he successfully bet that sterling would drop out of the European exchange rate mechanism in the early 1990s. Less well appreciated in the wider media was the fact that so many other players also had such a great year in 2007. Of the winners at the Absolute Return Awards in New York, nine had returns of over 50 percent for the previous twelve months and four of them had returns of well over 100 percent.
The story was not too dissimilar last year in Europe and Asia. Emerging market strategies were undoubtedly the place to be again in 2007.
In Asia, it was a very tough year again for Japanese players but elsewhere the markets were hot. The AsiaHedge Composite index was up only 9.23 percent for 2007, although this disguises a lot variation – with Japanese funds down on average more than 2.5 percent (still much better than the Nikkei 225 index, which was down about 11 percent) while ex-Japanese funds were up by an average of more than 24 percent. This helps to explain why players focusing on India and China almost needed to be scoring triple-digit returns simply to compete for awards last year. The AsiaHedge Fund of the Year duly did so, with admirably low volatility in such a wild market.
That said, the markets were still very challenging in 2007. At the time of writing they did not look like getting any easier in 2008. This in turn was raising question marks about the industry’s ability to sustain its outperformance going forward. Overall, although most funds had a good year in 2007, many had also suffered significant reverses in August and again in November and 2008 began with what looked like an even tougher month in January.
A sustained period of tough markets will no doubt bring renewed focus on the question of whether hedge funds in general can continue to perform. If markets are really difficult there will doubtless be a rise in the shutdown rate, which has been calculated as roughly 8-10 percent of the universe shutting down each year, on average between 2000 and 2007. This in turn will attract major media attention if there are also any major casualties.
We have been here before. Back in the steep bear market of 2000-2003, it was similarly difficult and many funds disappeared. Hedge funds on average did outperform the market and by massive amounts. Arguably, it was this very bear market period of massive outperformance that began to attract so much institutional money into hedge funds, in recent years.
Research showed there was no let-up in the growth rate of the industry in 2007, at least during the first half. The industry’s assets – based on analysis of the 10,000-plus funds in databases and associated surveys – saw combined industry assets surge past the $2 trillion level at the beginning of last year and on to nearly $2.5 trillion by the middle of the year.
These surveys showed that the lion’s share of the industry’s assets, still about three-quarters of the total, is still managed from the US, with the Billion Dollar Club alone (including just those single-manager firms in the US with at least $1 billion in hedge fund assets) accounting for nearly $1.5 trillion at mid-year.
At the same point of time, European hedge funds accounted for assets of nearly $540 billion. Asia-Pacific hedge funds were weighing in at $167 billion, with falling assets in the Japanese strategies being more than offset by a rapid rise in ex-Japanese. Adding in the fast growing smaller markets, such as Brazil and South Africa and adjusting for double counting (such as for US firms that run Asian or European funds), the global aggregate hedge fund assets reached $2.48 trillion last July.
The sustained out performance and lower volatility of hedge funds over the previous economic cycle had clearly left a long and deep impression on investors.
Since almost seven years ago industry pundits have been predicting the eventual or imminent demise of the fund of funds sector on the basis that end-investors would sooner or later “cut out the middle man” and start to allocate to hedge funds directly. In practice, however, this has simply not happened – or certainly not yet.
In practice, a large proportion of the new money coming into the industry from institutional investors like pension funds is continuing to be allocated via the funds of funds – with the Billion Dollar Club (counting just those multi-manager firms with at least $1 billion invested in hedge funds) soaring for the first time to well over $1 trillion by the end of 2007. Adding in all the smaller funds of funds (those running less than $1 billion) it is clear that close to 50 percent of the industry’s assets is still being allocated via the fund of funds sector.
Clearly, the industry still faces some significant challenges. Those challenges have no doubt been increasing, due not least to the growing size and importance of hedge funds, with ever more managers regarded as “activist” investors driving the agenda of the corporate world, even before any performance issues arise.
It is for reasons like this, that groups of major hedge funds banded together last year, with endorsement from AIMA, to participate in the Hedge Fund Working Group in London and the President’s Working Group in the US. These initiatives will hopefully help the industry to keep itself clean - and seen to be clean – by setting voluntary standards and avert the risk of heavy-handed and invasive new regulations.
A key issue, however, will of course continue to be performance. If hedge funds can show their mettle again this year, by being able to protect capital on the downside, just as they did in 2000-2003, then there will be no let-up in the demand from investors.