Alternative Investment Management Association
Hedge funds had a healthy year in 2007, with the composite Eurekahedge Hedge Fund Index up a solid 13.4 percent. This compares favourably with performance during the last three calendar years – 14.4 percent (2006), 12.2 percent (2005) and 10.5 percent (2004). The year’s performance has weathered credit related woes, the attendant risk aversion and drying up of liquidity in the underlying markets, which manifested themselves early in the third quarter of 2007. The ensuing down month (August -1.9 percent) was one of only two in the last twelve. The other negative month was November (-2 percent), largely owing to profit booking. After a pro-active Federal Reserve a larger-than-expected 50 basis point cut in the interest rates in mid-September led to a return of optimism into the markets during the following months.
In this write-up, we take a closer look at the strategy/ regional aspects of the year’s performance, and also at how this performance has shaped asset flows into the industry. The analysis includes a comparison of key hedge fund strategies against their peers in the long-only and fund of funds spaces.
To review the performance of various hedge fund strategies in 2007, we compare two measures of the same in Figure 1 below – absolute return and risk adjusted return (i.e., Sharpe ratio). On the basis of the combined measure, style based performance during the year may be classified into four broad categories, in the order of preference of a typical risk averse investor; high-return/low-risk, low-return/low-risk, high-return/high-risk and low-return/high-risk (assuming a Sharpe ratio of 1 or above as indicative of a low-risk strategy and annual returns of 12 percent or above as indicative of high-return).
While the majority of hedge fund strategies have returned close to or upwards of 12 percent on the year, an equal number of them appear to have been affected by the mid-year market turmoil caused by the meltdown in the US sub-prime markets. This has had a negative effect on risk adjusted returns across the board, with the understandable exception of multi-strategy funds. It is interesting to contrast this with a similar analysis of strategy wise performance in 2006 – five of the ten strategies studied were squarely in the top performing category of high-return/low-risk; event driven, distressed debt, arbitrage, relative value and multi-strategy.
Of course, this is by no means a reflection of the quality of the year’s returns per se, as this has to be viewed in the context of conditions in the underlying markets. Significant activity levels (new issuance as well as secondary markets) in the M and A and high-yield spaces favoured opportunistic strategies during the earlier half of the year. On the other hand, arbitrage and relative value players benefited from the market volatility ensuing from the sharp market correction in the third quarter of 2007.
By comparing the quarterly returns generated among the various hedge and long-only strategies, one can appreciate the impact of underlying market conditions on hedge fund performance during the year. It is evident that most strategies have significantly underperformed during the latter half of the year. The notable exceptions were, (owing to reasons stated earlier), managed futures, global macro and relative value funds. Managed futures and macro funds benefited from clear trends in the energy and currency markets during the second half of the year (oil and gold prices rose by over 50 percent and 30 percent respectively), while an upward rise in volatility and mis-priced assets worked in favour of relative value players.
On the flip side, strategies such as event driven, distressed debt and fixed income were directly affected by the tightening credit conditions and the drying up of liquidity in the M and A, and high-yield markets. They were either flat or shed some of the gains made during the strong, bullish trends of the first half. The case with long-only strategies was similar. These returned 13 percent in the first half and a mere 3 percent in the second.
Asset Flow Overview
The direction of asset flows and asset growth during 2007 was largely shaped by fund performance and subscriptions/ redemptions, while inflows owing to fund start-up activity (US$ 4 billion) had only a marginal impact on asset growth. Net industry inflows during the year are estimated at US$ 193.5 billion, which translates into an 8 percent decline in inflows year-on-year (inflows in 2006 exceeded US$ 211 billion) and a 13 percent rise in total assets from US$ 1.45 trillion as at the end of 2006 to the current US$ 1.65 trillion. These numbers mask quite a bit of turbulence intra-year; inflows during the first three quarters of the year added up to US$ 316.3 billion, which was nearly twice the size of inflows during the same period in 2006. These were offset by net outflows to the tune of US$ 122.8 billion during the fourth quarter 2007. Figure 2 below depicts the key components of these asset flows in each of the four quarters, contrasting the nature of flows between hedge funds and long-only funds. The figure also charts an asset growth index (AGI) for either type of fund (equalised to 100 as of the end 2006).
It is interesting to note that hedge funds and long-only funds had different drivers of asset growth during 2007. A case in point is the nature of flows in the fourth quarter of 2007, the main driver of which was negative performance in the case of hedge funds and redemptions in the case of long-only funds. It is fair to surmise that a portion of these assets leaving long-only vehicles were re-allocated to more conventional hedge fund strategies during the fourth quarter of 2007.Back to Listing