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The Flow of Smart-Money – a Comparative Analysis of Long/Short Equities vs Long-only Absolute Return Funds
Rajeev Baddepudi, Hedge Fund Analyst
Eurekahedge
February 2006


Introduction

The Eurekahedge database has now grown to cover over 200 long-only absolute return funds (ARFs) that together represent in excess of US$27 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.

This write-up aims to give the reader an overview of the ARF market space, followed by a comparative analysis of their performance vis-à-vis traditional long/short hedge funds.

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 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.

In terms of strategies employed, we categorise long-only ARFs into Bottom-up/Value, Top Down, Dual approach and Diversified Debt. The most popular investment strategy for long-only ARFs remains the bottom-up approach, with close to 56% of the US$27 billion allocated to this strategy. In terms of number of funds too, this is the dominant strategy, accounting for nearly 70% 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 – The Eurekahedge Bottom-up Absolute Return Fund Index was up 31.1% for 2005 and has an annualised return of 16.1%.

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 (11.5% returns in 2005), with dual approach ARFs still generating far better returns (23.6% during the same period).

In terms of geographic investment mandate, long-only absolute return funds may be categorised into – Global Emerging Markets, Asia Pacific (including Australia/New Zealand), Japan, North America and Global. The biggest gains for long-only ARFs in our database were made in Emerging Markets, which account for close to 50% of the ARF asset flow and whose 2005 returns stand at a spectacular 43.2%. Another 30% of the ARF assets are parked in pure Asian strategies. This is reflective of Asian fund managers' appetite for long-only investments, as well as the fact that opportunities abound in these regions for absolute returns to be made without shorting or using leverage. By contrast, the North American ARFs returned just 4.1% in 2005.

Comparative Performance Analysis

Because ARFs started out essentially as off-shoots of conventional long/short hedge funds, in an environment of shrinking opportunities for the latter and a lack of shorting avenues in the high-growth emerging markets, this section seeks to evaluate the rationale behind this trend through an analysis of their comparative performance in different investment regions over the years.

Figure 1 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 the returns of were also similar at 101.2% and 88.3% respectively, between December 1999 and December 2005. 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 1: Movements of Eurekahedge Asian ARF vs Long/Short Hedge Fund Indices

Contrast the above with the relative performance chart for a more developed market like, say, North America (Figure 2). 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 63.5% versus 90.6% 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 2: Movements of Eurekahedge North American ARF vs Long/Short Hedge Fund Indices

And finally, Figure 3 looks at the relative performance of the emerging market indices, and in contrast to the Asia-Pacific indices in Figure 1, shows a far clearer trend of long-only ARFs outperforming their long/short counterparts. The Eurekahedge Emerging Markets ARF Index returned 382.6% against the long/short index' 173.3%, between December 1999 and December 2005.

Figure 3: Movements of Eurekahedge Emerging Markets ARF vs Long/Short Hedge Fund Indices

Conclusion

To conclude, the trend of smart money venturing into the long-only market space – a trend started in the US by hedge funds a few years ago – is increasingly gaining ground in the emerging markets in general, and in Asia Pacific in particular. Long-only funds have a particular appeal for Asian equity-focused managers because they traditionally tended to be long-biased. The rationale for their growth in the emerging markets, on the other hand, has to do with strong corporate fundamentals coupled with liquidity-fuelled growth over the past few years.

Notes:

Investment Strategies
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.


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