In last month’s issue, we looked at how supply and demand for hedge funds played out through the year, and how the terms of business set between buyer and provider have changed, particularly for single manager hedge funds. We now look a level down from industry level impacts to effects on individual strategies. The focus thereafter is on funds of hedge funds.
Strategy returns
Last year the Credit Suisse/Tremont Hedge Fund Index, a good proxy for single manager performance, was down 19%. This year single manager hedge funds are up around 13%. It is very striking looking down the second and third columns of Table 1; as bad as last year was for returns at the strategy level, it is proportionately good this year. What was up is down and vice versa. Further, what was down most is now up most. So last year’s best investment strategies (commodity trading accounts, or CTAs, and short selling) are this year’s laggards, and 2008’s worst performers (emerging markets and convertible arbitrage) now lead the ranks. In fact this is also true at the level of the individual hedge fund. Individual funds which lost the most in 2008 have gained the most in 2009. According to work by TrimTabs the correlation of individual hedge fund returns in 2008 to returns in 2009 is –0.543 which is statistically significant, but also significant for investors in hedge funds. This reversal of fortunes at the strategy and fund levels has implications for funds of funds in particular, which shall be picked up later, but first a look at how the returns were produced this year.
Market environment and risk assumption by equity hedge funds
Although the assumption that managers’ ability to harvest alpha within each strategy is consistent through time is questionable, an inference of the returns produced is that for strategies with positive returns this year, the market environment is as benign now as it was tough last year. The reverse would be true for those strategies that were up last year and are down this. However that would not be sufficient to explain the scale of returns. There is more to it than that. Given publicly available data, the easiest strategy to look at further is equity long/short.
Based on public 13-F filing information from hedge funds domiciled in the US, it is possible to aggregate exposures to generate a strategy level balance sheet, at least on a quarterly basis. Equity hedge funds in Europe change their balance sheets in the same direction as those in the US, though the starting point may differ. So looking at US hedge fund data tells us about the direction of change of US, European and – to an extent – Asian equity hedge funds’ exposures. The derived balance sheet disposition of equity hedge funds is given in Table 2.
So from the middle to the end of last year equity hedge fund managers cut their gross exposures by 60% and their net long exposures by a third. This year equity hedge fund managers kept the same level of risk assumption from year end to the end of the first quarter, and as equity volatility dropped and markets rebounded in the second quarter of this year managers took their net exposures back to pre-crash levels.
Working by inference, Goldman Sachs analysts concluded that in US equity markets, long-only buying dominated in March, May and June (Fig.1). Hedge fund short-covering took place in April, and contributed significantly to the stock market rally from mid-July and into August of this year. Digging down to the sector level, hedge funds are no longer net short of shares in financial companies, according to Goldman Sachs. After holding an aggregate net short position in financials since Q1 2008, hedge funds reassumed a net long exposure to the sector in Q2 2009, resulting from considerable buying and participation in equity capital raises, as well as significant short covering.
Gross exposure has not recovered to the same degree as net exposure to markets (year-on-year) because managers have taken account of intra-market correlation and volatility. Traded equity index volatility has dropped to around 25% recently from nearly three times that last October, and 40% at the end of 2008. Like volatility, correlation between stocks has dropped to the high end of the normal range, having been at record levels last year (Fig.2). As of 18th August 1009, average stock correlation in the S&P500 was 0.38, versus a peak of 0.70 last year. So hedge fund managers have not needed to carry as much gross exposure this year to have the same level of gross risk assumption as they had in the middle of last year. Taking account of the market risk environment, hedge funds have assumed a higher level of net risk at current levels of net exposure (more than 30% in the third quarter) than they did in the middle of 2008.
To change the comparison period, hedge fund managers are now taking as much balance sheet (exposure) risk as they did in the first half of last year. Hedge fund managers in aggregate vary the fund level net exposure with the equity market direction and with a lag. As market directional moves became extreme, exposures were cut with the usual lag last year. What has happened this year is that the lag has increased – the net has built a lot slower than the market recovery. Understandably market psychology did not allow anything other, for the aggregate. Hence hedge funds have produced absolute returns this year, but equity hedge funds have captured only 30% of the market’s rise from the lows. Historically investors in hedge funds looked to hedge funds to capture around 70% of market rises and 30% of market falls. So a key question one year on from the Lehman collapse is: will recent returns in equity hedge be enough to sustain interest from investors?
Funds of funds
Surveys of investors in hedge funds show that they continue to be invested in them for the same reasons as ever. This year’s Alternative Investment Survey from Deutsche Bank had the usual top three responses – diversification, low correlation to other asset classes and absolute returns (Fig.3).
Last year those rationales for investing in hedge funds were met by the 30% of single manager hedge funds that produced positive absolute returns. Far fewer funds of hedge funds achieved absolute returns apart from those specialising in particular investment strategies. Amongst the better performing multi-managers last year were Culross, Ermitage and – to an extent – Aurum, Oakley, Liongate and the Lyxor funds of funds. The outcomes investors in hedge funds got is reflected in the annual returns of indices of funds of hedge funds and single manager hedge funds shown in Fig.4. Both last year and so far in 2009, most hedge funds have failed to deliver diversification and low correlation whether through single manager or multi-manager programmes.
The relative performance of funds of funds last year is consistent with that delivered historically. The 2008 performance of the HFRI Fund Weighted Composite Index exceeded that of the HFRI Fund of Funds Composite Index (single managers over multi-managers) by 2.9%. That is bang in line with the average differential performance over the last dozen years, which includes the last major market liquidity crisis before that of 2008 (see Table 3). So last year investors in funds of hedge funds got what might be termed a typical return relative to that produced by single manager hedge funds. But 2008 was not a typical year in finance. During and just after the 1998 Russia default crisis (the last global liquidity crunch) fund of fund returns as measured by the HFR Composite Index were substantially adrift of single manager returns. In 2008 adverse selection had far less impact on fund of funds in aggregate. So funds of funds did relatively well last year compared to their own history of relative returns. The inference is that the increasing focus on portfolio construction and risk management, particularly outlier risk, by funds of hedge fund firms has impacted returns in 2008 compared to 1998.
A case for similar relative success cannot be made for funds of funds in aggregate in 2009. Year to date and using the same HFRI benchmarks, single manager hedge funds are up 14% whilst funds of hedge funds are up 8% (Fig.4). Investors in funds of funds in aggregate may be less content with the returns on their investment this year than those investors investing directly in hedge funds across the universe. But is this rational?
In part one of this review of the industry, we covered the experience of investors trying to redeem from hedge funds last year – gates, nested-gates, queuing and stacking of redemptions and suspension of redemptions all together were common events. Cash was raised from hedge fund investments, but it was a brave or unusual investor who was willing or able to put that cash to work promptly in different hedge funds this year.
For example CalPERs cut back on its list of hedge funds but has yet to allocate to all its new funds. Funds of funds cannot turn on a dime in terms of redeeming and subscribing to hedge funds; there are lags of notice periods in normal times. The consequence is that the strategy allocations (and manager selections within strategies) change gradually over time at funds of funds. Recall that at the strategy and fund level, last year’s winners are this year’s laggards, and vice versa. Even if the senior staff at funds of funds could select what would be winning strategies and funds over a six to 12 month forecasting horizon it has been extraordinarily difficult to execute the redeeming part even if the subscription part has been achievable. So a working hypothesis would be that, given some stability of core investment strategies and funds, funds of funds should mirror single managers in comparisons of performance in 2009 over 2008 (best become worst). The case is easily made for specialised funds of funds: a fund investing in equity hedge funds specialising in emerging markets would have been badly hurt last year, and be doing well this year. A fund of funds such as Coronation Global Equity that was down 40.2% last year should be up 31.28% this year. The same for the Clariden Leu Asia Equity Fund, down 36.81% in 2008 and up 18.91% in 2009.
Table 4 gives examples of mainstream diversified funds of funds the returns of which support the hypothesis.
For balance, it is true that not all the funds of hedge funds that did badly last year did well this year and vice versa. Table 5 gives some of the funds of funds that qualify for this minority report. It is interesting that at least two funds of internal funds from hedge fund groups make it into the minority report. Brummer’s Multi-Strategy Fund and FrontPoint’s Multi-Strategy Fund did not experience reversals of fortune in 2009 after a good or relatively good 2008. By turns, the managers of these two funds and funds like them have in certain ways both more and less freedom than independent funds of funds: they can change allocations (including cash) more promptly and radically than a typical fund of hedge funds, but they are very constrained in the strategies and managers they can select from.
Despite the evidence of the minority report illustrated in Table 5, the hypothesis is generally true for funds of funds: there was a reversal of fortunes in returns in looking at 2008 versus 2009 return on a relative and absolute basis.
Performance and asset flow impact
Last month, we looked at how performance and asset flows impacted the terms of business of single manager hedge funds. We shall do the same funds of hedge funds now. Just as single manager business models have been pressured by events of the last year or so, so have those of funds of funds. It appears from HFR data that the commercial pressures have remained stronger for longer on funds of funds when compared to single manager hedge funds. Nearly twice the proportion of funds of hedge funds (5%) went out of businesses in Q2 of 2009 compared with single manager funds. The attrition rate amongst funds of funds, like that for single manager hedge funds, was lower in Q2 than Q1 of 2009 (5.04% versus 8.16%).
Funds of hedge funds managed total capital of $530 billion at the midway point of this year according to Hedge Fund Research. This is well below the $825 billion figure of the middle of last year. One of the trends of the industry used to be an increasing proportion of the industry assets were channelled via funds of hedge funds. This trend has reversed in recent times, and at current levels funds of funds manage 37% of the industry’s assets. This partly reflects the differences in net flows experienced over the last year. So for example there were net inflows to single manager hedge funds in May and June this year, but funds of hedge funds continued to experience net investor redemptions in both months.
This is being cited by some industry observers as early evidence that some groups of investors will be shunning their hedge fund intermediaries and going direct.
From database analysis it is clear that funds of hedge fund fees are still under pressure, but they are not declining dramatically: 18 months ago the average management fee in the HFR database of funds of funds was 1.28%, and at the end of the first quarter this year it was 1.25%. The average management fees charged by funds of funds were 1.24% at the end of the second quarter.
Another way of assessing the dynamics of fee levels is by surveying. Alternative asset information provider Preqin surveyed single manager and funds of funds in April to June 2009 on fee structures. Their research showed average fund of fund management fees of 1.26% and performance fees of 10.60%. Preqin also gave a distribution of management and performance fees across their sample – see Fig.5 and Fig.6.
So typical fund of fund management fees are 1.25%, but there are significant differences between the data providers on performance fees. HFR’s data essentially shows most have a performance fee of 5% with some at 10%, whilst Preqin shows performance fees at 10% with a few outliers above and below that level. The difference could well be accounted for by the locations of the manager or their clients’ locations in the different samples.
Table 6 shows that fee levels vary by manager location. It is suggested that Preqin has a non-US bias relative to HFR in its sample of managers, and that performance fees are significantly lower in the US because of the maturity of the market there and the increasing impact of pension plans on hedge fund terms of business.
The marginal client sets the priceHistorically, US endowments and foundations were the institutional investment group with the highest allocations of assets to hedge funds, followed by the large Japanese insurers. But the continued support of both groups for the hedge fund industry at the same level is now in doubt.
Barclays Capital surveyed more than 300 investors in hedge funds by conducting interviews between December 2008 and March 2009. The American endowments and foundations signalled their intention to reduce their hedge fund exposure this year, Barclays found. Japanese insurers cut hedge fund exposure last year, some fairly radically, and are reducing their exposures this year. Tokio Marine, Japan’s biggest casualty insurer, disclosed in July that it plans to trim its hedge fund investments, while Meiji Yasuda Life Insurance Co., Japan’s third largest life insurer, has hedge fund investments of only 40% of the level a year ago through a combination of redemptions and capital losses.
Pension funds in the US and Europe mostly maintained their hedge fund allocations over the last year, with a few minor exceptions. In addition, fund of fund providers are seeing interest from potential new clients. This suggests that whilst the case for diversification and low correlation through hedge funds is not strong for the most extreme market circumstances, the case can be made for most market conditions. A number of UK local authority pension schemes have initiated searches for hedge fund providers and smaller corporate pension schemes in Europe and the UK are talking to their consultants about hedge funds. Aggregators of French assets are also seeing first-time interest from French regional banks.
However, bookending the waning interest from private client investors, the most significant positive development amongst hedge fund clients is the increasing prominence of US pension plans. Intermediaries say that the investment departments of US pension plans are looking to invest in hedge funds where they started a relationship with the hedge fund provider (single and multi-manager) 12-months ago or more. The implication is that the market turmoil caused a hiatus in the net flows of pension assets into hedge funds, but that it starting to resume. Pension funds have $437 billion invested in hedge funds, and more is coming, though at a measured pace as yet.
The impact of the market turmoil a year ago on single manager and multi-manager hedge fund returns and terms of business has been covered here, and also how those areas have been impacted in the year since. Perhaps the biggest legacy of that year is that the hedge fund industry has to recognise that it is increasingly serving institutional investors to a degree not experienced to date. If and when US pension plans become the marginal suppliers of capital to the hedge fund industry some nascent trends will become clear to all.
There will be increased use of separate accounts and third-party transparency systems. There will be more rational fee structures including more hurdles, multi-year performance fees, and clawback provisions. Permanent changes to the terms of trade (between supply and demand) in the hedge fund industry are the first major consequence of the events of the last year.
Unlike endowments and foundations, US pension plans can have substantial internal investment staff. They often outsource some areas of investment to external specialists and carry out the mainstream investment activities themselves. US pension plans learn about areas of investment through co-opting external expertise, often employing consultants with specialist knowledge in the early days. Then they use outside specialists to run the investment strategies – several different providers are often used at the same time. Eventually they seek to reduce their costs by bringing the mandates in-house, and employing passive versions of the investment strategies.
US pension plans have been investors in hedge funds for a number of years. Applying their standard mode of operation to hedge fund investing could mean that the percentage of the hedge fund industry managed by funds of hedge funds has already peaked. This is the second major consequence of the events of the last year. Funds of hedge funds have peaked.
