Introduction

The number of European hedge funds has grown rapidly over the last ten years, and the European hedge fund industry has witnessed a healthy growth both in terms of assets under management and the number of funds. By the end of 2005, the total number of European hedge funds is expected to hit 1,650 with total assets amounting to about US$350 billion (approximately 30% of the global hedge fund industry), more than double that of 2003.

Growth in Number of New Launches since Dec 1987

The average growth rate by number of funds during the last five years has been around 29% per annum and the annualised growth rate for AUM since 2000 has been around 30%. Performance wise, the Eurekahedge European Hedge Fund Index has been generating an annualised return of almost 10% per annum with an annualised volatility of 5% since 2000.

Out of the total asset flows in 2005, around 29% went to hedge funds with a European mandate, and this has been increasing year on year (up from 27% in 2004). The UK remains the most attractive destination for starting up hedge funds in Europe (around 60 launches in 2005 year to date). Switzerland is the second most popular choice (10 launches during the same period), with France and Ireland catching up. Of all the funds based in Europe or with a European mandate, around 57% had their head offices based in the UK and around 9% in the US.

New funds launched today also appear to have a stronger focus on structure, for example risk controls and external directors, than they were four years ago.

Performance Commentary

I. Risk vs return analysis

While European equity markets are down by around 8% from their first quarter 2000 highs, European long/short equity hedge funds held up very well with total returns of over 75% over the same period.

In our risk-adjusted rankings (Jan 2000 to Oct 2005), European distressed debt funds were the best performers, with an annualised return of 18.17% and a volatility of just 7.71%. This is followed by arbitrage and event driven funds. On the same criteria, the worst performers in the European space since Jan 2000 are CTA funds. Their Sharpe ratios remained well under 1 during the period.

II. Average assets vs risk-adjusted returns analysis

The graph below plots the average assets per strategy in the European universe versus the Sharpe ratio per strategy. Distressed Debt draws our particular attention - the large positive Sharpe ratio coupled with low average asset suggests that there could be a lot of potential in this strategy and could well be the dark horses in the European space in the coming future. This can be attributed to managers' growing interest in emerging markets in the Americas, as also in Central & Eastern Europe (European funds allocating to the Americas have seen a doubling of assets since 2000, albeit from a low base). Having said that, future change in inflow rates for different hedge fund strategies will depend on allocators' perception of where returns will come from and investment constraints.

Average Assets vs Sharpe Ratio

III. Index comparison

The extent to which the Eurekahedge European Hedge Fund Index and the Eurekahedge European Equity Long/Short Hedge Fund Index have outperformed the benchmark MSCI All Countries European Equity Index since Jan 2000 can be termed exemplary.

Amongst their regional peers, European hedge funds lag behind (although not by a huge margin) their Asian counterparts, which overtook Europe since mid 2003, due to the huge Asian 2003 bull run.

Index Comparison

The comparison of wealth creation table below gives the micro view of returns produced by the three indices plotted in the index comparison chart above. It is interesting to note that between 2000 and 2002 when the MSCI AC Europe had a huge drawdown of 43%; European hedge fund indices not only outperformed the index but generated a positive return of 32%.

Producing Alpha

The performance comparison chart is a clear evidence of alpha produced by European hedge fund managers. European long/short strategies not only outperformed the MSCI All Countries European Equity Index (Dec 1999 to Dec 2002) but produced positive returns when the markets took a plunge during the same period. In fact since Dec 1999, the Eurekahedge Europe Long/Short Equities Hedge Fund Index has netted only positive returns irrespective of the market conditions. However, we must keep in mind that all funds are heterogeneous and that the spread on funds vary across different investment managers.

European Hedge Funds vs European Equities

Correlation Stats (Jan 2000 to Oct 2005)

Given that almost 40% of the European hedge fund assets adopt a long/short equities strategy, they offer a high degree of diversification from the local equity indices. The correlation figures of the Eurekahedge Long/Short Index with respect to the MSCI AC Europe Equity Index as well as to the S&P 500 Index are extremely low as well, indicating that it can be used as a powerful tool by portfolio managers for risk management purposes.

Sector Analysis

I. By assets under management and number of funds

Of all the hedge funds with a European mandate, long/short equities is the most popular strategy both in terms of number of funds and assets under management, accounting for almost half of the universe in both areas.

Breakdown of European Hedge Funds (Number) by Strategy

Excluding long/short equities funds, European hedge funds are fairly distributed amongst the other strategies, except for distressed debt and event driven strategies which form a miniscule number of funds in the European space at present.

Breakdown of European Assets by Strategy (US$m)

Looking at the asset flow trend table (below), assets allocated to long/short strategies increased their share from 37% in 2002 to 46% in 2005 year-to-date. During the same period we saw a similar trend for CTA / managed futures and arbitrage funds where the assets allocated to these strategies grew significantly as compared to 2002. Bucking the trend however were relative value and fixed income funds; but overall these same funds are still amongst the fastest growing funds by assets since 2000.

The growth chart below shows an interesting comparison between the annualised growth rates for assets under each strategy relative to the annualised growth rates in the number of funds. While the asset growth rates for relative value, distressed debt and multi strategy funds stand out amid their peers, the growth rate in the number of funds are more or less within a similar range.

The asset growth rate for distressed debt, fixed income, multi strategy and relative value funds have exceeded their respective growth rates in the number of funds, which suggests that the average assets being pumped into these funds are larger than their other counterparts since 2000. This is not surprising if we look at the annualised returns of these strategies since 2000, which have been amongst the best performers. This was brought up by the increase in global corporate activity, which fed through to the region, and created more opportunities for these funds in terms of merger and acquisition activities, as well as debt restructurings.

European Hedge Fund Growth by Investment Region

II. By investment mandates

Almost half of Europe-based assets have a global mandate (48%), followed closely by Europe and the rest of it allocating to the emerging markets, particularly Asia and Latin America.

Breakdown of European Hedge Funds by Investment Mandates

The growth chart below suggests that the American region has been the flavour of the European investment managers since 2000, suggesting a healthy demand for American products. Hedge funds with a Latin American mandate have been the best performers since 2000.

European Hedge Fund Growth by Investment Region

III. By head office locations

The UK takes the lion's share in terms of the hedge fund assets being managed out of Europe, suggesting the high demand for hedge fund products there. This has been mainly due to the availability of retail and institutional investors, as well as skilled managers which re-asserts the prominence of London as the financial nerve centre for Europe. The annualised fund growth in the UK has been around 30% since 2000 and the assets registered a 60% annual growth over the same period.

Breakdown of AUM by Head Office Locations

However in terms of growth in assets over the last five years, Sweden outshone the rest. Sweden has also been growing in popularity as the choice of location to set up offices. Though it is currently home to a mere 2% of the assets managed out of Europe, this number is set for a significant change in the next few years if Sweden is able to sustain this explosive growth. Switzerland and the US are doing well too, being the second- and third-fastest growing markets in terms of growth in assets.

Comparatively, the lower growth rate of UK in terms of assets and number of funds probably indicates that the local market is reaching a mature growth phase.

Growth by Head Office Locations

Outlook

Overall, the outlook for the European hedge fund industry remains solid with assets growing at 30% per annum (signalling high investor confidence) and annualised returns close to 10% since 2000. The excellent performance of European hedge funds was not even dampened by the significant withdrawal of their assets by global funds of funds in early 2005. With the exception of October, which was a bad month for hedge funds all round because of some market corrections as well as the fact that management costs were booked in the accounts, the later half of 2005 has been a period of healthy returns for European hedge funds. And we expect this trend to continue until at least the end of the year.