The Eurekahedge Absolute Return Fund (ARF) Database has now grown to cover over 200 long-only ARFs that together represent in excess of US$20 billion in managed assets.
Long-only ARFs are a recent addition to the alternative investment landscape and have grown in both size and number only in the past few years. Their increasing popularity among institutional investors is driving more hedge funds – leveraging on their presence and experience in the equity markets – to launch long-only products. Also, over the years, huge capital inflows into hedge funds have brought on an environment of shrinking conventional opportunities, especially on the short side. Hence these funds find the long-only space a lucrative alternative, particularly so in relatively harmless, if not positive, equity market conditions.
Furthermore, long-only funds have a particular appeal for Asian equity-focused hedge fund managers, who have traditionally tended to be long-biased. This is reflected in the trend – of hedge funds venturing into the long-only market space – that started out in the US but is increasingly gaining ground in Asia.
This write-up aims to give the reader a detailed overview of the ARF market space, starting with a look into some of the key features that differentiate long-only funds from their peers in the hedge and mutual fund space, and followed by a review of some of the key performance and other trends therein with respect to strategies employed, regions invested in, fee structures and service provider mix.
Long-only Absolute Return Funds – A Primer
To return to a more basic line of inquiry, what are long-only ARFs? They are like hedge funds (that can take short positions), in that they too strive for "real" returns. This is in contrast with traditional mutual funds, whose returns are relative and which strive to outperform an index benchmark. The table1 below gives a more comprehensive overview of the differences between hedge funds, long-only absolute return funds and mutual funds.
Table 1: Salient and Distinguishing Features of Long-only ARFs
|Long-only Absolute Return Funds||Hedge Funds||Traditional Mutual Funds2|
|Objective is consistent positive returns in all market conditions||Objective is consistent positive returns in all market conditions||Objective is outperformance of index benchmark; depends on rising markets for positive returns|
|Flexible investment strategies including derivatives but no "speculation"||Flexible investment strategies including active use of derivatives||Limited flexibility, generally must be fully invested|
|Seldom invests in other long-only ARFs or traditional funds||Hedge funds that are funds of funds do invest in other alternative funds||Seldom invests in other traditional funds|
|Leverage used sparingly||Leverage permitted, average 1.6:1 (assets + liabilities/NAV)||Leverage rarely used|
|Mostly open-ended; available to a limited number of qualified institutional investors||Mostly open-ended; available to a limited number of qualified institutional investors||Generally open-ended; widely available to retail and institutional investors|
|Large minimum investment||Large minimum investment||Small minimum investment|
|Shares or units subject to limited liquidity, normally bought and sold any business day and are required to meet a minimum holding period for redemption but rarely a lock-up period||Shares or units subject to highly restricted liquidity, can be bought and sold any business day and are required to meet a minimum holding period for redemption but rarely a lock-up period||Shares or units subject to daily liquidity and can be bought and sold any business day without any notice whatsoever|
|Manager's capital often at risk||Manager's capital often at risk||Manager's capital not at risk|
|Fees derived from management fee; manager awarded a percentage of profits||Fees derived from management fee; manager awarded a percentage of profits||Fees from management fee; manager paid salary and bonus by company|
|Highly skilled, experienced and knowledgeable managers||Highly skilled, experienced and knowledgeable managers||Generally less experienced and specialised managers|
|Restricted from advertising and marketing||Restricted from advertising and marketing||Generally aggressively advertised|
|Tends to be registered investment||Private investment, loosely regulated when offshore||Registered investment (US SEC and other authorities)|
|Loosely correlated to stock markets and traditional asset classes (diversification benefit)||Loosely correlated to stock markets and traditional asset classes (diversification benefit)||Strong correlation to stock markets and traditional asset classes (no diversification benefit)|
|Usually private placement||Private placement||Public placement|
|Long only||Long and short selling allowed||Long only|
|Actively managed||Actively managed||Actively managed|
The reasons for the rising trend of traditionally long/short funds entering the long-only absolute return space are not too difficult to seek. The huge influx of money into hedge funds, shrinking opportunities for high absolute returns through traditional hedge fund strategies, and a positive equity environment conducive to the risk exposure required of long-only funds, all of these provide the external impetus for the shift. Fund managers, with their existing operational and human capital and stock-picking skills, are in a position to exploit these opportunities. This is particularly true of fund managers in emerging markets in general, and Asia in particular, where traditionally, fund performance has tended to more strongly correlate with equity movements. This makes the jump from traditional to long-only strategies relatively easier for hedge funds investing in Asia.
What follows is a review of some of the key trends in the ARF market space, including an analysis of returns as well as the assets under management, by criteria such as investment strategy employed, manager's location and investment region.
From Figure 1 it is apparent that the most popular investment strategy3 for long-only ARFs remains the bottom-up approach, with close to 50% of the US$20 billion allocated to this strategy. In terms of number of funds too, this is the dominant strategy, accounting for about 60% of the ARFs in our database. This is due to the fact that most fund managers entering the long-only ARF space do so on the strength of their superior stock-picking skills – essential to any successful bottom-up approach. In a favourable equity environment, an experienced and skilled manager can generate absolute returns without shorting or using leverage. Long-only funds employing this strategy have been able to generate handsome returns – about 20% year to date and close to 16% annualised (see Table 2).
Figure 1: Breakdown of Assets under Management by Strategy
On the other hand, diversified debt funds seem to be gaining ground as a popular strategy, taking away share from funds executing the dual approach. In our last review, over a quarter of the long-only ARFs were employing the dual approach. The performance figures are a little less favourable for diversified debt funds (8.2% YTD), with dual approach ARFs still generating far better returns (13.6% YTD).
Geographic Investment Mandate
The various regions that long-only absolute return funds invest in may be categorised into – Global Emerging Markets, Asia Pacific (including Australia/New Zealand), Japan, North America and Global.
As is clear from Figure 2 and Table 3, the biggest gains for long-only ARFs in our database were made in the emerging markets, which account for nearly 50% of the ARF asset flow and have YTD returns of 35.8%, exceeding even the returns generated in this region for the whole of 2004 (24.5%). This is reflective of Asian fund managers' appetite for long-only investments, as well as the fact that opportunities are abound in these regions for absolute returns to be made without shorting or using leverage.
Figure 2: Breakdown of Assets under Management by Region
The next best returns by long-only ARFs were from investments in Europe. These funds have been up 12.6% during the year to date as compared to 9.3% for 2004, suggesting that seasoned hedge fund managers are increasingly seeking long-only absolute returns in Europe, and more specifically, in the developing markets in Russia and the Baltic states.
The top location by YTD returns is Sweden, with returns at a spectacular 69% YTD, compared to the overall average YTD returns of 16.2%. Interestingly enough, six of the top-10 funds in our database by YTD returns (with YTD returns at about 80% on average) are located out of Sweden and are managed by just two fund managers. As many as eight of these funds have an investment mandate entirely focused on emerging markets (with the other two investing in the Asia-Pacific region).
Figure3 gives a location-wise breakdown of the long-only funds in our database – by number and by assets managed5. Since our last review, the UK has retained the top spot, nearly doubling its assets under management. This is not that surprising, given London investors' appetite for alternative vehicles. Hong Kong has moved from the third to second spot, with assets growing by more than 1-1/2 times. Sweden is the new entrant into the top three. This is largely due to the fact that the 13 funds that make up Sweden's share are managed between only two fund managers, both of whom have a track record in Russia and/or the Baltic states, and would be capitalising on this through long-only absolute return investments.
Figure 3: Breakdown of Funds by Manager's Location
Long-only ARFs returned an impressive 5.05%4 for the month of September 2005 and an equally impressive 16.2%4 YTD.
Figure 4 below is a look at the performance of the Eurekahedge long-only regional indices. ARFs in developing markets have outperformed ARFs in developed markets by a considerable margin. The Eurekahedge Emerging Market6 ARF Index has risen by 347% since December 1999, while the corresponding North American index has been more or less flat, rising by only about 49% over that period. This illustrates the extensive upside to returns (and by extension, the increasing appeal) that rising emerging markets – with their attendant market inefficiencies – hold for managers of long-only funds.
Figure 4: Movements of the Eurekahedge ARF Regional Indices
Figure 5 below compares the performance of Asian long-only funds against their equity long/short hedge fund peers. As can be seen from the graph, the performance of the respective Eurekahedge indices in the last six to 12 months has not been appreciably different, and both returned roughly 76% over the years. To look into the reasons for this is to realise that institutions and infrastructure for shorting are not yet fully in place in Asia, and this can shoot up transaction costs and affect returns for long/short funds. This also explains why Asian long/short hedge funds' exposure to the equity markets has traditionally had a long-bias.
Figure 5: Movements of Eurekahedge Asian ARF vs Long/Short Hedge Fund Indices
Contrast the above with the relative performance chart for North America (Figure 6). ARFs in North America had a far rougher time as compared to traditional long/short funds in the region. The Eurekahedge North American ARF Index returned 49% versus 88% by the Long/Short Fund Index, from December 1999 to date. This is again reflective of the kind of opportunities available to long-only funds in emerging markets as opposed to the developed markets. To elaborate, the North American markets afford substantial availability of research and information on small- and mid-cap stocks, making it that much harder for funds to find or take advantage of information asymmetries with regard to undervalued companies.
Figure 6: Movements of Eurekahedge North American ARF vs
Long/Short Hedge Fund Indices
Administrators are an important link in an ARF's value chain. They support a wide range of the fund's back office functions such as accounting, valuations, transfer agency and custody services, thereby allowing managers to concentrate on the return-generating aspects of the business. Needless to say, hiring the right administrator – one that works closely with clients and provides regular feedback – is of no small importance.
This explains the concentration of over 40% of the funds in our database among the top four players. On the basis of assets under management, these players hold nearly 60% of the market share. HSBC holds the top spot, with International Fund Managers and Bank of Bermuda (which HSBC acquired in October 2003) not too far behind.
And yet, the total number of players has grown from 35 (which in itself is quite a high number) to 45 since our last review, which is another indication of the lucrativeness and growth potential of this investment space.
Long-only ARFs, as the name itself suggests, do not borrow securities and so, do not require the extensive financial and market-making services that a prime broker typically has on offer for hedge funds employing long/short strategies. Nearly all long-only funds execute their trades through several brokers. And of course, in the absence of the need for a prime broker, these funds do not pay prime brokerage fees.
Long-only ARFs do not speculatively short and therefore do not employ leverage extensively. Their use of derivative instruments is rare, and when made, the use tends to be for hedging rather than speculative purposes. Furthermore, the average size and frequency of their transactions tend to be less than that of traditional hedge funds. And as discussed above, the administrator provides custodian services and can even settle transactions – services typically rendered by prime brokers for their peers in the hedge fund space.
As can be seen from the above table, one of the key differences between long-only absolute return funds and traditional long-only funds such as mutual funds is the fund managers' expertise and flexible investment mandate. To compensate managers of ARFs for their superior skill sets in analysing securities and making winning investment choices, the incentive-based fee structure of hedge funds has been borrowed by long-only ARFs.
While almost all ARFs charge a management fee ranging from 0.5% to 2.5% of NAV, the bulk of managers' remuneration comes from performance fees, with over 70% of the funds in our database charging a 20% fee on gains in excess of their respective hurdle rates. About two-thirds of the ARFs require that returns reach a high water mark before performance fees may be charged, and understandably charge a higher fee than funds that are not subject to such a clause. About 35% of the ARFs also require that a hurdle rate or a minimum target return be reached.
Bottom-Up/Value: A value-based investment approach. Managers are predisposed to and focused on stock selection and conduct in-depth, rigorous fundamental analysis of individual securities. Additional effort is made to find mis-pricing opportunities (undervalued assets) and growth companies via company visits and scrutiny of accounting practices.
Top-Down: Managers base their holding decisions largely on country, region and sector selection, credit creation and other major macro considerations. Portfolios typically consist of a blend of debt and equity. Rigorous tests of businesses are also conducted, in similar fashion to Bottom-Up, although growth is the manager's priority.
Dual Approach: A mixture of Bottom-Up and Top-Down – the best illustration of a combination of securities selection and asset allocation. Emphasis is on stock-picking with a macro overlay.
Diversified Debt: The manager aims to capitalise on expectations of credit improvement in one or more of distressed, high-yield, sovereign, corporate and bank debt. Profitability depends on credit spread tightening. Convertible bonds (equity) can also be held.
1 Please refer to the Notes section at the end of this article for explanations of some of the ARF-related terms used in this table and elsewhere in the article.
2 Not including passively managed index funds (also known as tracker funds).
3 More elaborate explanations of these strategies can be found in the Notes section.
4 Based on a sample of about 150 funds out of the 200 in the Eurekahedge ARF database.
5 Adding up to about US$20 billion.
6 Emerging Markets include the investment regions of Latin America, Central & Eastern Europe and Asia ex-Japan.