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Introduction
The Eurekahedge Global Fund of Funds Database
contains information on 1,975 funds of funds.
Based on this and related information, we estimate
the total size of the fund of funds universe at
US$370 billion. While the fund of funds space
has grown both in size and number over the past
year, the pace of growth (6% by number and 55%
by assets) has slackened relative to the frenetic
levels seen in 2003 (23% by number and 129% by
assets) and 2004 (17% by number and 173% by assets).
Figure 1 below gives a more comprehensive picture
of the industry growth over the years.
Figure 1: Growth in Number and Size of Funds
of Funds Over the Years
This write-up aims to review some of the underlying
key trends in the size, structure and performance
of the fund of funds universe, to help better
understand this growth. The data used in the analyses
of the various trends, are based on the size,
structure and related details of a sample of 1,855
funds of funds, and the performance and asset
growth details of 804 funds of funds.
Current Industry Structure
I. Strategy Employed
Funds of funds, by definition, seek diversification
of their asset allocations with respect to geographic
mandate or investment style or both. It comes
as no surprise then, that the majority of the
funds of funds in the Eurekahedge database are
multi-strategy funds and/or funds with a global
investment mandate. As can be seen from the figures
below, 74% of the industry's assets are in multi-strategy
funds of funds (Figure 2) and close to 70% of
the same assets are invested globally (Figure
3).
The equity long/short strategy, with a 12% share
of total assets, is the next most popular among
funds of funds. That said, funds of funds allocating
to hedge funds employing other strategies such
as macro are gradually gaining ground and the
asset flows pertaining to this trend are discussed
elsewhere in this write-up.
Figure 2: Breakdown of Fund
of Funds Assets by Strategy
II. Geographic Investment Mandate
On an analysis of the composition of fund of
funds assets by investment region, it is apparent
that, aside from those with a global mandate,
these funds are mainly parked in North American
vehicles (26%), and only marginally in Europe
and the Emerging Markets (6%). But these assets
do find their way into higher return generating
markets, given that nearly 50% of the assets in
North American hedge funds have a geographic mandate
outside North America.
Figure 3: Breakdown of Fund
of Funds Assets by Investment Region
III. Location of Management Company
Table 1 shows that the United States, the United
Kingdom and Switzerland are the most popular locations
for funds of funds to set up offices in. Between
them, they account for nearly three-fourths of
all funds of funds. This is hardly surprising,
considering that the traditional key players in
the global fund of funds space have been private
banks and pension funds from these regions. As
a case in point, nearly 90% of the assets in Asian
hedge funds come from these three locations, although
not necessarily entirely from funds of funds.
A look at the average size of fund of funds assets,
however, tells a slightly different story. Hong
Kong, owing to its sophisticated financial markets
vis-à-vis other markets in the region,
has been rising as a key Asian location, especially
for funds that are keen on a more "ear to
the ground" approach to investments in the
region. So, while its footprint in terms of number
of funds is still rather small, the average size
of assets located in Hong Kong (US$148 million)
is the largest among all locations – an indication
of the robust returns in the region.
Table 1: Composition of Funds
of Funds by HQ Location
| HQ Location |
% Share by Number
|
% Share by Assets
|
Avg Asset Size (US$m)
|
| Hong Kong |
1%
|
2%
|
148
|
| France |
5%
|
8%
|
133
|
| Luxembourg |
1%
|
1%
|
123
|
| United States |
34%
|
46%
|
121
|
| Channel Islands |
2%
|
2%
|
107
|
| Switzerland |
14%
|
12%
|
77
|
| United Kingdom |
23%
|
19%
|
74
|
| Cayman Islands |
2%
|
2%
|
71
|
| Ireland |
1%
|
1%
|
67
|
| Bahamas |
1%
|
1%
|
56
|
| Canada |
1%
|
1%
|
51
|
| Netherlands |
2%
|
1%
|
42
|
| Bermuda |
7%
|
3%
|
30
|
| Others |
6%
|
2%
|
30
|
Growth in Assets
Seen purely in terms of growth rates, it would
appear that the pace of growth in the size of
funds of funds this year has slackened in comparison
with that of the last couple of years. The industry
registered robust year-on-year asset growth of
173% in 2004, against the relatively modest 55%
in 2005. However, this is a case of starting from
a lower base, and the quantum of asset growth
was not significantly lower than that seen in
2004. Fund of funds assets grew by an estimated
US$131 billion in 2005 and by about US$151 billion
in 2004.
Now, for a review of how this growth was distributed
among the various strategies and investment regions:
Table 2 depicts the year-on-year growth in assets
in some of the fund of funds strategies. In a
year that saw uniformly lower growth rates as
compared to 2004, macro funds notably registered
above-average growth, rising 96% over assets parked
in these funds in the previous year.
Table 2: Asset Growth Rates
by Strategy
| Year |
2005 |
2004 |
2003 |
| Arbitrage |
7% |
13% |
8% |
| Equity Long/Short |
51% |
208% |
90% |
| Macro |
96% |
156% |
23% |
| Multi-Strategy |
71% |
158% |
231% |
| Others |
28% |
39% |
29% |
As more funds of funds direct their assets towards
the emerging markets, as evidenced by the comparative
year-on-year asset growth rates for Asia Pacific
in Table 3, they are bound to gain in depth and
we might see an increase in funds focusing on
other strategies such as macro, relative value
and event-driven funds of funds. For instance,
in terms of average asset size, event-driven funds
of funds are already the largest in our sample
(US$143 million). In comparison, multi-strategy
funds have an average size of US$94 million, and
long/short funds US$63 million.
Table 3: Asset Growth Rates by
Investment Region
| Year |
2005
|
2004
|
2003
|
| Asia Pacific |
729%
|
284%
|
371%
|
| Europe |
31%
|
21%
|
37%
|
| Global
|
56%
|
108%
|
161%
|
| North America |
31%
|
210%
|
200%
|
Performance Review
I. Performance by Strategy
Funds of funds had a moderately good run in 2005,
with the benchmark Eurekahedge Fund of Funds Index1
rising 7.6% for the year. Barring the low volatility
of the initial few months and the end-of-the-year
profit-taking in October, markets have been, in
the main, positive. Among the strategy indices,
equity long/short (+10.64%) and distressed debt
(+8.72%) funds of funds were the top performers
on the basis of YTD returns, benefiting from robust
equity markets and tightening credit spreads respectively.
But on a ranking by risk-adjusted returns in
order to compare returns over a longer term, as
shown in Table 4, arbitrage funds of funds turn
up tops with an annualised return of 6.7% and
a volatility of just 2.2%. Distressed debt funds
are the next best return-generators with an annualised
return of 9.4% and a volatility of 5.3%. This
is owing to the concentrated and isolated evaluative
model followed by these strategies.
Table 4: Risk vs Return (in
%) by Strategy
| Investment Strategy |
% Share (No.)
|
2005 YTD2 Return
|
2004 Return
|
Annnualised Return
|
Sharpe Ratio
|
Rank
|
| Arbitrage |
3.0%
|
3.72
|
3.65
|
6.67
|
2.63
|
1
|
| Others |
0.4%
|
8.54
|
7.93
|
9.7
|
1.73
|
2
|
| Distressed Debt |
1.3%
|
8.72
|
12.08
|
9.41
|
1.61
|
3
|
| Multi-Strategy |
68.0%
|
7.25
|
8.36
|
7.81
|
1.51
|
4
|
| CTA |
2.0%
|
1.35
|
-1.2
|
9.99
|
1.43
|
5
|
| Macro |
1.4%
|
4.04
|
2.73
|
7.45
|
1.4
|
6
|
| Event Driven |
0.9%
|
5.3
|
8.79
|
7.6
|
1.39
|
7
|
| Equity Long/Short |
19.0%
|
10.64
|
7.62
|
6.7
|
1.11
|
8
|
| Fixed Income |
2.0%
|
4.69
|
7.79
|
5.48
|
0.98
|
9
|
| Relative Value |
2.0%
|
5.91
|
6.31
|
5.16
|
0.85
|
10
|
Figure 4 tries to uncover "dark horse"
strategies that are expected to do well in the
near term, by pitting the average size in each
of the strategies against the respective Sharpe
ratio. It is evident that arbitrage, CTA and macro
funds are low on asset size but high on risk-adjusted
returns, suggesting that there could be a lot
of potential in these strategies. This would of
course be subject to the allocators' perception
of investment avenues and constraints.
Figure 4: Average Assets vs
Risk-adjusted Returns by Strategy
II. Performance by Investment Region
Among the five broad investment regions, Emerging
Markets are of particular note, as they have recorded
not only the highest returns for 2005 YTD (a stellar
22.6%), but also the highest annualised returns
(9.5%) over the years. They are also among the
top-performing regions on the basis of risk-adjusted
returns (Table 5). This is hardly surprising,
considering the heightened interest in the emerging
markets of Asia, Latin American and Eastern Europe,
in recent years.
Table 5: Risk vs Return (in
%) by Investment Region
| Investment Region |
% Share (No.) |
'05 YTD Retn |
'04 Retn |
Ann. Retn. |
Sharpe Ratio |
Rank |
| North America |
13% |
5.89 |
7.62 |
7.56 |
0.95 |
1 |
| Emerging Markets |
2% |
22.56 |
14.54 |
9.47 |
0.89 |
2 |
| Global |
72% |
6.67 |
7.6 |
7.58 |
0.88 |
3 |
| Europe |
6% |
11.52 |
8.35 |
7.65 |
0.79 |
4 |
| Asia Pacific |
6% |
13.58 |
8.24 |
4.24 |
0.46 |
5 |
And as is apparent from Figure 5, the emerging
markets also seem to be slated for further growth
in the near term, as more funds chasing these
high risk-adjusted returns, flow into the region.
Figure 5: Average Assets vs
Risk-adjusted Returns by Investment Region
III. Index Performance
Three clear trends may be noticed from the following
index comparison chart – 1) both the Eurekahedge
fund of funds and hedge fund indices have outperformed
the MSCI equity index; 2) fund of funds and hedge
fund indices have similar trend lines and the
former trail the latter; and 3) multi-strategy
indices have more or less consistently outperformed
long/short indices, particularly so in the case
of fund of funds indices.
While none of these trends are really surprising,
what is impressive is the margin by which hedge
funds and funds of funds have outperformed the
benchmark equity index, reaffirming the ability
of these funds to generate absolute returns irrespective
of market conditions.
Figure 6: Index Comparison
Chart
Outlook for 2006
Going into 2006, the investment environment looks
very positive for funds of funds. This is not
merely owing to the momentum of the second half
of 2005.
Investment region wise, while Asia Pacific is
still enjoying significant asset inflows (refer
to Table 3); funds of funds are increasingly broadening
their emerging markets exposure beyond Asia. Although
both the indices turned in robust returns, the
Eurekahedge Asia-Pacific Fund of Funds Index was
consistently outperformed by the emerging markets
index over the past couple of years. The former
returned 8.2% and 14% respectively, to the latter's
14.9% and 20.2%. We expect 2006 to witness a surge
in asset inflows into other emerging markets such
as Latin America and Eastern Europe. Despite three
years of gains, valuations continue to be reasonable
because profit growth has overtaken share price
growth.
On the strategies front, prospects for arbitrage
funds of funds look promising. Assets in arbitrage
funds, particularly convertible arbitrage, have
shrunk considerably after healthy returns in the
past (as implied by the annualised return of 6.7%
and the 2005 return of just 3.7% – refer
to Table 4). Furthermore, a buoyant world economy
and strong corporate profitability and M&A
activity, should support, if not boost, global
equities in the near term, spelling good news
for equity long/short and special situations funds
of funds.
On the whole, 2006 presents a benign growth picture.
Having said that, it would be prudent to examine
some of the potential negative surprises such
as decelerating profit growth, rise in inflation,
reduced consumer spending or a collapse in property
prices in the US or Asia. Any of these would cause
a decline in global trade, adversely affecting
fund of funds performance.
Footnotes
1With 803 constituent funds.
2Year-to-date returns
until November 2005.
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