The 2007/2008 edition of the Eurekahedge European Hedge Fund Directory1 contains information on 2,176 Europe-centric funds, an investment space currently valued at US$448 billion. Contrasted with an industry size of US$20 billion at the end of 2000, this represents an impressive compounded annual growth rate of 62% over the past six-and-a-half years. We estimate industry assets to reach US$494 billion by end-2007, managed by nearly 2,200 funds. The following graph charts the growth of the industry over the past decade, together with forecasts for 2007.
In this write-up, we seek to explain this robust growth in the European hedge fund space by examining key aspects of industry growth such as the strategic and geographic direction of investments, fund age, size and capacity dynamics, and the evolving incentive fee structure. We evaluate these on the merits of performance where necessary, and also compare them with findings from a year ago where applicable. The write-up also includes a comparative analysis of performance both within the peer group of European hedge funds as well as against other regional hedge funds and asset classes. The charts, tables and data used in this report are based on the size and structure details of 8,364 funds in the Eurekahedge databases, and the performance details of 4,447 of them.
Industry Make-up and Growth Trends
Age and Size
If the aforementioned growth curve is anything to go by, the European hedge fund industry is arguably at the “take-off” stage, if not the “high turnover” stage, of its lifecycle, with a surfeit of new entrants. This is evident from the rise in average fund size over the years – from US$35 million ten years ago to the current US$219 million. Also, average AuM at launch has gone up from US$50 million to US$109 million over the same period. But this also raises some pertinent questions: do younger/newer funds perform better? What bearing does fund size have on performance?
Figure 2 tackles these questions by comparing average past 12-months’ returns of funds of varying ages and sizes. It is to be noted that the depiction of funds within a certain AuM range as a single bar irrespective of age, is intended to make comparison easier and does not imply cumulating returns. Also, let us assume for the purposes of this specific discussion, that it is possible for a fund to remain in a particular AuM range or of a particular age as it increases in age or size respectively. Simply put, the aim is to keep one of the two variables (age and size) constant, while we study the other’s impact on performance.
Figure 2: Age-wise and Size-wise Analysis of Performance
With that assumption in place, Figure 2 throws up some interesting observations: first, younger funds show a propensity for increasing returns as they progress in size but hit a certain point beyond which returns diminish on average. For instance, 1-year old funds have seen their average (annualised) returns go up from 9% when they had less than US$20 million in assets, to 18% when their assets were in the range of US$200-500 million, and this increase is more or less progressive. These same funds were down to 11% returns once they crossed the US$500-million mark. A similar trend can be noticed with funds that are anywhere between 1 and 4 years old.
Second, funds with a long track record and a small asset size have a clear edge. The best returns of the lot (39%) came from funds that were over ten years old and had under US$20 million in assets. Indeed among all funds over ten years old, those with less than US$100 million in assets performed better on average than those with over US$100 million. This intuitively makes sense, as size hinders the ability to make inconspicuous bets in the underlying markets (leveraged or otherwise).
Third, funds with a 5- to 10-year track record have seen stable returns (barring a few exceptions attributable to sample selection bias) irrespective of their asset size. More specifically, funds with US$500-1,000 million in assets witnessed diminishing returns with increase in size when younger than four years, and increasing returns when older. Given that the majority of funds with over US$500 million in assets have global and/or multi-strategy mandates, a longer track-record does go some way in explaining the better performance.
The growing number of new entrants into the industry also warrants a closer look at capital-raising and hedge fund capacity within the European hedge fund space. To this end, using capacity and launch size information of a sample of 807 European hedge funds in the Eurekahedge databases, Figure 3 compares the percentage of AuM capacity filled against asset growth since inception and against past 12 months’ return, across strategies.
The rationale behind this comparison is to take into account capacity constraints at the strategy level, as well as at the fund/manager level. That is to say, the rate at which a fund absorbs assets would depend on the strategy employed, the timing of the investments, as well as a broad ‘optimal’ size that allows a fund to remain nimble in a dynamic market environment.
Figure 3 brings out several interesting points. For one, the industry has room for growth, as our data points to about 20% filled capacity on average. Secondly, as discussed in the earlier section, smaller funds with a longer track record tend to perform significantly better than younger and/or larger funds. At the fund manager level, this implies a reluctance to absorb large subscriptions into the fund. Coupled with growing demand from institutional investors (global fund of funds allocations now account for over 45% of global hedge fund assets), this would mean that asset flows seep into managers constrained by their strategy/resources, bringing down average returns in that strategy. The case of distressed debt funds in Figure 3 seems to illustrate this – the strategy has seen a significant jump in average size since launch (from US$2 million to US$400 million) as also 40% of industry capacity filled on average, but returns over the past year (up to Jun-07) have averaged about 10%. Event-driven funds on the other hand, have only seen about 15% of their capacity filled although average fund size has gone up significantly since launch (from US$40 million to US$630 million), and they returned upwards of 15% for the year to Jun-07.
In some cases, the increasing demand for hedge fund exposure has had the effect of institutional investors seeking out emerging managers (ie funds with a shorter track record). Again, as observed in the earlier section, younger funds with assets between US$50 and 500 million tend to perform better than their older peers. Of course, a fund’s track record is not the same thing as the managers’, and due diligence and manager selection would still play a role in allocation decisions.
Figure 3: Average Fund Size and Capacity Filled, by Strategy
Figure 4 charts the breakdown of assets in European hedge funds by strategy employed, and as is evident, equity long/short remains the dominant strategy by assets managed. Since our last review on the European hedge fund space a year ago, the strategy-wise market shares have only slightly changed, with long/short equity, fixed income and distressed debt funds receiving the bulk of increased asset inflows (a 1-2% jump in market share).
Figure 4: AuM Breakdown by Strategy
In terms of average fund size, however, event-driven funds continue to hold the top spot, with 4% of the total number of funds (2,043 funds) currently managing 11% of total assets (US$448 billion). Other strategies that have a high average fund size include distressed debt (US$304 million, up from US$262 million a year ago), multi-strategy (US$293 million, down from US$312 million last year) and arbitrage (US$253 million, down from US$286 million last year). In contrast, average fund assets in the equity long/short strategy have gone down from US$157 million to US$142 million within the last one year. This again points to the broadening scope of hedge fund assets with respect to strategies pursued in the European markets.
The general direction of asset flows into hedge fund strategies is also broadly reflected in a comparison of the performance of these strategies over the last two years (up to Jun-07) in Figure 5. During a year that saw strong positive trends in the equity, M&A and credit markets, distressed debt, event-driven, fixed income and equity long/short managers have all shown improved returns over the past 12 months, both on an absolute and on a risk-adjusted basis.
Figures 7 and 8 chart the distribution of European hedge fund assets among key manager locations and regions of fund investment. The current breakdown of assets among European regions and locations shows a marked change since our last review of a year ago. While global and Europe-focused allocations still soak up over 80% of the assets, several key trends emerge: a) the asset share of funds with a global mandate has gone up from 50% to 58%; b) funds with a pure Europe mandate have seen a corresponding drop in their share of assets; c) funds with a broad Emerging Markets mandate (7% share against last year’s 9%) are branching out into more region-specific allocations such as Eastern Europe & Russia, Middle East & Africa, and Emerging Asia.
In terms of centres of hedge fund management, on the other hand, the United Kingdom continues to be a popular destination garnering over three-fourths of the hedge fund assets in the region, with France a distant second at 6% of total assets.
Figure 6: AuM Breakdown by Geographic Mandate
*EE&R refers to Eastern Europe & Russia; ME&A refers to Middle East & Africa. Source: Eurekahedge
A comparative analysis of performance by region over the past two years (Figure 8) corroborates the direction of asset inflows into Europe-based funds, with improving returns across the board in the past 12 months (up to Jun-07). More specifically, funds allocating to Eastern Europe & Russia and the Middle East & Africa continued to show the highest gains in the past year both on absolute and risk-adjusted terms.
The diversification into region- or country-specific allocations is also justified by the returns that such funds are generating. Furthermore, none of the funds investing in emerging markets (single or multi-country) during the past 12 months had negative returns to speak of.
There is a certain demand-supply dynamic at play in an industry that is witnessing many firms enter and leave the market. We set out to examine whether this has had an upward or downward pressure on overall hedge fund incentive fees. In order to do so, we compared the weighted average incentive fees charged by hedge funds of different ages on the one hand, and new hedge fund launch activity over the past 15 years on the other (Figure 9). Adjusting for short-term highs and lows from year to year, Figure 9 shows a perceivable downward trend in average fees charged. Notably, in the last seven years, a marked increase in the number of start-ups has had the effect of initially steep, then flattening, fee rates.
Looking at the same graph from a different perspective, older funds distinguish themselves from more recent entrants with their longer track records, and hence, can command higher fees. A comparison of average hedge fund size by fees charged also supports this. Although average fund size is on the rise (billion-dollar launches are no longer unheard of), hedge funds have traditionally started on a smaller scale (over one-third of the hedge funds surveyed had assets under US$20 million each, whereas funds with over US$1 billion in assets accounted for a mere 5%) and tend to have an optimum size beyond which returns begin to diminish. So, on a comparison of average fund size and fees charged, we observed that the two share a direct relationship funds that are larger in size can conceivably attract capital through either superior trading strategies or longer track records or both, and hence can afford to charge higher fees.
In this section, we seek a broad overview of European hedge fund performance to see how they fare as an investment option. To this end, we have reviewed their performance against two parameters – other regional hedge fund vehicles and other modes of alternative investment.
The review also seeks to add to a similar survey we ran a year ago, where, to facilitate an analysis of performance under different market conditions, we decided to compare the average returns (annualised) of the types of funds detailed above over a 9-year period (May-97 to Apr-06) in blocks of three years. Three years is a reasonable amount of time to factor in the influence of long-distance runners as well as sprinters (with a head-start afforded by benevolent market conditions) into the average performance numbers, while the 9-year comparison offered an opportunity to study performance under both rising and falling markets. The broad conclusion in our previous survey was that European hedge funds offered more stable, if lower, returns across varying market conditions.
As a preface, we compared the performance of the Eurekahedge European Long/Short Equities Hedge Fund Index against that of an appropriate European equity market benchmark – the MSCI Europe Index – over the period since the inception of the Eurekahedge index in Dec-99 (Figure 10). While this does not quite account for the diversity of strategies and underlying asset classes among hedge fund allocations, it is still fairly representative, considering that equity-focused strategies currently make up over 50% of the funds and 40% of the assets managed in Europe. As is evident from Figure 10, European hedge funds have seen very stable returns in sharply downward trending markets (Dec-99 to Apr-03), whereas in bullish markets, they have risen in step with, if not in excess of, underlying equities.
We have seen in previous sections of this write-up, how age, size and investment style can affect returns among European hedge funds. But were an investor to contemplate building a portfolio that comprises only hedge funds, would European funds be preferable to their counterparts in North America, Asia or Latin America? To answer this question, we compared the average returns (risk-adjusted and otherwise) as well as the quartile dispersion of returns, for each of the regional hedge fund spaces2 over the past 12 months. This is depicted graphically in Figure 11.
Figure 11: Mean and Quartile Returns across Regional Hedge Funds
As is clear from the figure above, European managers have been significantly outperformed by emerging market hedge funds in both Asia and Latin America. However, they now offer returns on par with, if not better than, North American managers, who have been outperforming their European peers over the past nine years. Furthermore, the range of returns among the funds surveyed is narrower for European (-27% to +112%) than North American (-51% to +105%) funds, suggesting a higher probability of picking a winner among the pool of European hedge fund managers.
Hedge Funds vs Other Alternatives
From our review thus far, it is evident that hedge funds in the region offer stable and improving (especially considering positive economic outlooks for most European economies) returns. Assuming that this pattern of returns suits the risk profile of an investor, it is still worthwhile to ask which mode of alternative investment to park one’s assets in. To this end, Figure 12 compares the performance of three kinds of absolute returns strategies that allocate to Europe – hedge funds, long-only funds and funds of funds – over the 12-month period up to Jun-07.
Evaluated purely on absolute performance, long-only funds are the investment vehicle of choice in Europe, with mean returns at an impressive 24%. However, it should be noted that the comparison with long-only funds needs to be adjusted for better performance during rising markets (refer to the positive correlation between the Eurekahedge Europe (long-only) Absolute Return Fund Index and the MSCI Europe (equity) Index, in Figure 10). Mean returns from hedge funds and funds of funds, on the other hand, were similar.
Looking at the dispersion of returns, however, especially for a risk-averse investor with a minimum acceptable return (MAR) of 10%, funds of funds offer the best returns, with three out of four funds of funds picked out of random meeting the MAR criterion. On a risk-adjusted basis too, funds of funds offer the best returns among the three fund types compared, with an average Sharpe ratio3 of nearly 3.
It is also indicative of the nature of the investment vehicles that despite similar ranges of returns among the funds surveyed (-25% to +110%), hedge funds and long-only funds differ significantly in their dispersion of returns between first and third quartiles.
Figure 12: Mean and Quartile Returns across European Alternative Investment Vehicles
Of course, in practice, the choice of investment vehicle boils down to their accessibility (especially the better-performing ones) to investors. This section is merely an exercise in enquiring the quality of returns for each fund type.
To recapitulate, the European hedge fund universe has seen tremendous growth over the last ten years, growing four-fold by number of funds and at over a 60% annualised rate by assets. And yet, their returns do not compare too favourably with those of most other alternative investment vehicles. But it is encouraging to note that the mismatch in asset flows and performance that we noticed in our previous review of the industry (strategies that saw the most asset flows were not necessarily the best performing) is correcting, and comparative and factor-wise analyses of their performance shows improving performance over the past year. The general direction in which the industry is headed is also positive. Allocations to the emerging markets continue to be on the rise, the consistency and stability of returns hints at superior managerial talent, and performance fee structures continue to evolve to accommodate more diverse investor demand.
On the macroeconomic front, favourable European economic data and largely robust corporate earnings have been staving off problems in the credit markets (owing to declining property values and rising foreclosures in the US subprime mortgage markets) until late July 2007, when they spilled over into other asset classes. Most markets were negatively affected by the ensuing sell-off, as investors re-evaluated their risk appetites and shifted their allocations to safe-haven assets. The current market environment is that of reduced liquidity, heightened volatility and concerns over the extent of contagion, but the fundamental picture for the European economy remains unchanged and favourable. Recent calls for the Federal Reserve to lower rates, as also the actions of the US, European and Japanese central banks in early August (for instance, the Fed injected liquidity into the financial system to the tune of US$38 billion by accepting mortgage-backed bonds as collateral) could prove helpful in allaying fears of a liquidity crunch.
From a hedge fund perspective, the high-volatility environment could offer profitable opportunities in short-term trading, as also attractive valuations at which to enter markets for a bet in the longer term. The outlook for global M&A activity remains strong despite steeper borrowing costs, as companies continue to boast strong free cash-flow yields, and this bodes well for risk-arbitrage and other opportunistic strategies.
1 The online database comprises 2,713 funds, including 172 (long-only) absolute return funds and 498 obsolete funds.
2 In a survey of 615 Asian, 929 European, 201 Latin American and 1,303 North American funds.
3 Return (annualised) per unit of risk, measured as the (annualised) standard deviation of monthly returns.