The 2008 edition of the Eurekahedge Global Fund of Hedge Funds Directory contains information on close to 2,400 funds1. Based on this and related information, we estimate the total size of the fund of funds universe at US$747 billion as of end-2007, up 20% from our end-2006 estimate and accounting for over 45% of global hedge fund assets (up from 43% a year ago). Judging by this and the performance of the Eurekahedge Fund of Funds Index (which rose a healthy 10% in each of the past two years), 2007 has, in the main, been a good year for the industry. The industry has seen impressive growth over the past decade – in terms of the number of funds as well as the size of assets – as can be seen from a comparison of year-end numbers charted in Figure 1 below.
Indeed the average fund size has grown from a modest US$27 million to the current US$225 million, in the last five years alone. It must be noted, however, that the rate of asset growth has somewhat steadied in the last couple of years (from 55% in 2005 and 35% in 2006, to 20% in 2007).
Figure 1: Industry Growth over the Years
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In this write-up, we aim to analyse the trends shaping the current structure of the industry and examine some of the reasons behind the aforementioned rapid growth (and how they impact asset inflows into new investment styles and new markets), followed by a review of fund performance and its contentious relationship to incentive fees, and finally a peer group analysis comparing fund of funds returns with those from other modes of alternative investment.
The data used in the various analyses are based on the size, structure and related details of 2,436 funds of funds and the performance and asset growth details of a sample of 1,179 funds.
1. Industry Make-up
While recent years’ growth in the fund of hedge funds industry may broadly be explained in terms of external factors such as the robust performance of the underlying financial markets (in terms of regions as well as asset classes), and the frenzied growth of the hedge fund industry (industry assets grew by 33%, while the composite Eurekahedge Hedge Fund Index returned close to 40%, over the last three years), this section takes a closer look at some of endogenous factors shaping and being shaped by this growth trend.
1.1. Fund Size
Given the marked upturn in industry asset growth since 2003, Figure 2 contrasts the distribution of funds across fund-size ranges between end-2007 and end-2002. As can be seen, there has been a marked increase in the number of smaller-sized funds (
Figure 2: Growth in Number of Funds by Size
While this suggests that newer funds have tended to be smaller-sized, Figure 3 goes on to answer the question of whether these were also the ones that grew the most in terms of assets; it compares the original and current sizes of funds of funds according to their year of launch. To make them comparable, we use the annualised asset growth rate of the funds launched each year. We observed that funds launched in 2004 enjoyed the highest growth in assets (68.6% on an annualised basis), clearly poised for the strong uptrend in global security markets, especially in the emerging markets. The upward trend started around mid-2003 and has continued its bullish run for most of the last three years. For instance, between January 2004 and December 2007, the MSCI World (equity) Index grew at an annualised rate of 11%. The Eurekahedge Hedge Fund Index returned an annualised 12% over the four-year period.
Figure 3: Growth in Total Assets from Year of Launch to date
On that note, we then compared the average annualised performance of all funds reporting a full set of returns to us (grouped into fund size ranges) over three different time-periods: the last 12 months (ie year 2007), the last three years (2005-2007) and the last five years (2003-2007), depicted in Figure 4. Similar research on Asian and European hedge funds uncovered an ‘optimum’ size for hedge funds – typically US$1 billion – beyond which average returns tended to diminish.
While the general pattern of small- to mid-sized funds turning in the best returns still holds true in the case of funds of funds, what is interesting to note in Figure 4 is the decidedly better performance of bigger funds (>US$1 billion in assets), especially in more recent years. As the majority of funds of hedge funds tend to be multi-strategy funds with a global mandate, the larger-sized funds would be better poised to access a wider set of opportunities in the aforementioned upward-trending markets. Furthermore, larger funds of funds are better positioned to access successful hedge funds and to tap into their superior returns, than their smaller-sized peers.
Figure 4: Annualised Past-period Performance by Fund Size
A more detailed analysis of the choice of investment strategy and regional mandate, and how that affects fund performance, is carried out in the sections below.
1.2. Strategic Mandate
As has been mentioned elsewhere in this write-up, the majority of the global funds of hedge funds tend to allocate to multiple hedge fund strategies, as also suggested by the 73% share of industry assets in multi-strategy funds (Figure 5). However, collated information on the actual breakdown of style allocations implies a far more equitable distribution of assets than Figure 5 would lead one to believe, and is shown in Figure 6. Multi-strategy allocations form a miniscule portion of total fund of funds assets, while equity long/short is the most popular with nearly one-third of industry assets parked therein.
Figure 5: AuM Breakdown by Fund Strategic Mandate
Figure 6: AuM Breakdown by Investment Strategy
While this characteristic feature of the industry would make it difficult to pin-point the exact nature of asset flows into various strategies, a look at comparative performance of these strategies (Figure 7) in recent years offers an alternative measure of the same. For instance, given strong bullish trends across the board during the first half of 2007, directional strategies such as macro and equity long/short, and multi-strategy funds, saw progressively rising returns over the past five years and the best gains in 2007.
Opportunistic strategies such as distressed debt and event driven, however, were more severely hit by the US subprime/housing market woes during the latter half of 2007, and the ensuing tighter credit conditions and eroding volumes in the high-yield and M&A spaces. For instance, distressed debt allocations, which posted the highest returns among all strategy allocations in 2006, have seen declining gains in recent months. On the other hand, returns from arbitrage and relative value allocations, while generally modest over the last five years, have benefited from the heightened volatility during 2H2007.
Figure 7: Annualised Past-period Returns by Strategic Mandate
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1.3. Geographic Mandate
We carried out a similar analysis of fund of funds assets, and in terms of regions of fund of funds investment, Figures 8 and 9 below mark the disparity in asset distribution between fund investment mandates and actual regions of investment.
Figure 8: AuM Breakdown by Fund Geographic Mandate
Figure 9: AuM Breakdown by Investment Region
Even so, a big portion (over two-fifth) of industry assets is still parked in the North American markets, while emerging market-centric allocations account for less than a seventh of the same. The increase in the volatility of hedge fund returns would go some way towards explaining the continued high allocation to global mandates; the annualised volatility of the monthly Eurekahedge Hedge Fund Index returns has progressively gone up from 3.2% in 2002 to 5.4% in 2007.
However, a comparison of performance by investment region (Figure 10), hints at superior returns from, and increasing asset flows towards, emerging market-focused funds. Performance in these funds has indeed steadily gone up over the past five years, with returns averaging 20% or above during each of the past five years. Fund allocations to Europe, however, have borne the brunt of the spate of market corrections and volatility during the latter half of 2007, especially in the region’s emerging markets in Russia and Eastern Europe.
Figure 10: Annualised Past-period Returns by Geographic Mandate
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1.4. Manager Location
The UK and US continue to be key centres of fund of funds management activity, with market shares of total number of funds at 27% and 25% respectively. Together with Switzerland (19% share of assets), France (4%) and offshore financial centres (14%) such as Bermuda and Channel Islands, these locations account for nearly 90% of total funds and over 95% in industry assets. A more detailed breakdown is provided in Figure 11 below.
The continued significance of these locations for fund of hedge funds managers can be explained by the fact that the choice of manager location is a function of both investor location as well as hedge fund location. To illustrate, nearly 60% of the assets in Asian hedge funds alone are managed out of the US and the UK, while investors in Switzerland, the US and the UK make up close to 90% of the sources of these assets.
Figure 11: AuM Breakdown by Manager Location
That said, the presence of manager locations such as Hong Kong, Australia and South Africa (currently accounting for roughly 1% share of total assets each) is not to be discounted. An increasing portion of new fund launch activity is being taken up by existing managers, as Figure 12 below suggests, in an effort either to spin off their larger global funds into region- or country-specific mandates, or to set up new offices in those regions/countries, or both.
Figure 12: Launch Activity by New vs Existing Managers
2. Cost of Return – A Review of Incentive Fees
In the previous section on current industry structure, we examined, among other things, fund of funds performance with respect to various fund attributes such as size, strategy employed and region of investment. While this suggests that returns are in healthy territory and have generally improved in recent years, it does not explain whether that warrants investment in funds of funds as opposed to other modes of alternative investment such as (long-only) absolute return funds and hedge funds. This section tackles the question of choice of alternative investment vehicle, by comparing the split among investors and fund managers of the average returns generated by these three different types of funds.
Furthermore, the incentive fees charged by funds of hedge funds have recently come under criticism because the returns generated from the underlying investments take two significant haircuts before they are eventually paid out to investors: in the form of incentive fees paid to the fund of funds managers, whose returns in turn are net of incentive fees charged by the managers of their underlying hedge fund investments. For instance, a hedge fund returns 15% for the year 2007 and charges an incentive fee of 20% of the returns generated. A fund of funds manager that had invested in this fund during 2007 would then receive only 80% of those returns, ie 12%. If the fund of funds manager then charges an incentive fee of 10% on those returns, this would mean that returns to an investor into that fund of funds would only be 10.8%. In this section, we examine how dear investing in funds of funds is as compared to investing in hedge funds or absolute return funds.
In order to perform the aforementioned comparative analysis, we took the average after-fee returns (for the three years to December 2007) of a sample of 1,515 funds of funds, 302 absolute return funds and 3,539 hedge funds, that report to the Eurekahedge databases, and charge an average incentive fee of 10.5%, 15.4% and 19.7% respectively. We then worked backwards using these averages to arrive at the average pre-fee returns of each type of fund. In the case of funds of funds, we performed an additional step of deducting another 19.7% from the pre-fee returns to account for the fees that the managers of the underlying hedge funds would have charged on average. This gives us an estimate of the ratio in which the returns are split between investors and fund managers, for different fund types. Applying these ratios to a hypothetical return of US$100, Figure 13 below offers a ready comparison of the cost to investor for each fund type.
Figure 13: Average Returns Split between Investors and Managers for Different Types of Funds
While on the face of it, absolute return funds charge a higher fee than their fund of funds peers, they actually pay the biggest portion of their returns (84.6%) back to the investors among the three fund types compared. Investments into fund of funds vehicles are much dearer by comparison, with the fee component accounting for nearly one-fourth of returns (22.5%).
3. Comparative Performance
To be sure, there is a difference between the rationale behind the fees charged by hedge funds and funds of hedge funds. While with the former investors pay for alpha, in the case of the latter they pay for portable alpha (ie the ability to improve alpha by diversifying across investment styles that are not correlated). The above analysis only presents one half of the picture. From an investor’s standpoint, returns, and the cost of returns, should be considered in conjunction with risk. To this end, in this section, we compare the dispersion of risk-adjusted returns, ie the Sharpe ratio2, of the three fund types over the last 36 months as depicted in Figure 14 below.
Figure 14: Mean and Quartile Returns across Absolute Return Strategies
While the healthy dispersion of risk-adjusted returns of long-only absolute return funds that we have seen during a period of largely bullish markets (up to the first half of 2007) have been somewhat dented by the volatile markets of 2H2007, a comparison of the return distributions among hedge funds and funds of funds holds more interest. As can be seen from Figure 14 above, global funds of funds had a much higher 1st quartile Sharpe ratio than their hedge fund peers. That is to say, 25% of the hedge funds surveyed returned less than 0.2% in excess of the risk-free rate, per annum per unit of risk3. Contrast this with the nearly 0.6% for the bottom-quartile fund of funds returns. Even the median fund of funds Sharpe is slightly higher than the median hedge fund Sharpe, pointing to a quality of returns in funds of funds that is better suited for the more risk-averse investor. This is of course assuming a randomness in investors’ fund selection process.
To summarise, the global fund of hedge funds industry has grown at a robust pace over the last few years, as more smaller-sized funds enter the market and funds increase their allocations into emerging markets and opportunistic strategies. The location of fund of funds managers, on the other hand, continues to be concentrated in a few centres such as the US and the UK, given the advantages of ready access to investors as well as hedge funds that are potential investment targets.
In a peer group comparison of global fund of funds performance against that of hedge funds and long-only absolute return funds, fund of funds returns seem to be achieved at a higher cost to investors, but this is offset by the fact that they offer steadier risk-adjusted returns.
In terms of performance, returns have generally improved over the past five years, owing in part to the strength of the underlying financial markets for the most part of the period in question. Looking ahead, fiscal and monetary measures taken by the US government and the Federal Reserve in the last month in an effort to avoid a sharp economic slowdown have yet to be proven successful, and it is very likely that markets will continue to be volatile in the coming months. Managers re-adjusting their portfolio allocations to reflect the current uncertainty in the markets are being cautiously optimistic, and pockets of opportunity continue to exist. Our outlook for industry growth and performance in 2008 remains positive.
2 The Sharpe ratio calculations use a risk-free rate of 4% per annum.
3 Measured as the annualised standard deviation (in %) of monthly returns.