The 2007 edition of the Eurekahedge Global Fund of Hedge Funds Directory contains information on close to 2,100 funds. Based on this and related information, we estimate the total size of the fund of funds universe at US$624 billion as of end-2006, up 35% from our end-2005 estimate and accounting for over two-fifths of global hedge fund assets. Judging by this and the performance of the Eurekahedge Fund of Funds Index (which rose 10% in 2006 in contrast to 7.7% in 2005), 2006 has, in the main, been a good year for the industry. The industry has witnessed exponential growth over the past few years – 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$23 million to the current US$223 million, in the last five years alone.
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 2,087 funds of funds, and the performance and asset growth details of a sample of 1,517 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 seen in 2001, Figure 2 contrasts the distribution of funds across fund-size ranges between end-2006 and end-2001. As can be seen, there has been a marked increase in the number of smaller-sized funds (<US$100 million), whose share of the total number of funds rose by 10 percentage points to 55% as of end-2006. This indicates a general lowering of the size-barrier, among other things, to new entrants into the industry. In fact, funds under US$20 million in size have seen the largest growth in market share (15% to 20%) among the size-ranges studied.
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, 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 2006, the MSCI World (equity) Index grew at an annualised rate of 13%, against 27% and 16% posted by the MSCI Emerging Markets Index and the Reuters-CRB (commodity) Index respectively during the same period. The Eurekahedge Hedge Fund Index returned an annualised 12% over the three-year period.
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 2006), the last three years (2003-2006) and the last five years (2001-2006), 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 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.
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 75% 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 only about a fifth of total fund of funds assets, while equity long/short is the most popular with over one-third of industry assets parked therein.
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, distressed debt allocations, while still generating the highest returns among all the strategy allocations compared, have clearly underperformed in 2004 and 2005 as compared to the two years prior to that, but have again picked up speed in 2006. Similar was the case with directional macro allocations.
On the other hand, assets in equity long/short, and to a lesser extent, arbitrage and event-driven strategies, have seen a much straighter progression in returns generated over the last five years, in step with bullish equities, heightened volatility and an increasing volume of opportunistic plays in recent years. Consequently, this pattern of returns has also played itself out in the case of multi-strategy funds.
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.
Even so, a big portion (over one-third) of industry assets are still parked in the North American markets, while emerging markets centric allocations account for less than a tenth 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% in 2002 to 5.3% in 2006.
However, a comparison of performance by investment region (Figure 10), hints at superior returns from, and increasing asset flows towards, emerging markets focused funds. Returns in these funds have indeed steadily gone up over the past five years, with 2006 returns breaching the 20% mark. Fund allocations to Europe have similarly been positively impacted by bullish emerging markets in Russia and Eastern Europe.
The United States and the United Kingdom continue to be key centres of fund of funds management activity, with asset shares at 29% and 24% respectively. Together with Switzerland (17% share of assets), France (5%) and offshore financial centres (14%) such as Bermuda and Channel Islands, these locations account for nearly 90% of industry assets. A more detailed breakdown is provided in Figure 11 below.
The continued significance of these locations for funds 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.
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 above 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.
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 2006 and charges an incentive fee of 20% of the returns generated. A fund of funds manager that had invested in this fund during 2006 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-fees returns (for the three years to December 2006) of a sample of 1,520 funds of funds, 266 absolute return funds and 3,204 hedge funds, that report to the Eurekahedge databases, and charge an average incentive fee of 8.29%, 8.69% and 19.25% 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 19.25% 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 (91.3%) 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 subtle 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 Ratio1, of the three fund types over the last 36 months as depicted in Figure 14 below.
While the healthy dispersion of returns of long-only absolute return funds during a period of largely bullish markets should not come as any surprise, 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 have 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 risk2. Contrast this with the 0.4% for the bottom-quartile fund of funds returns. Even the median fund of funds Sharpe is slightly higher than the median hedge fund Sharpe, suggesting that funds of funds offer better and more stable returns than hedge funds, on a risk-adjusted basis.
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 terms of performance, returns have steadily improved over the past five years, owing in part to the strength of the underlying financial markets.
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 light of the above, our outlook for industry growth and performance in 2007 remains positive, especially given the continuing boom in M&As and a generally positive corporate and economic outlook in the global financial markets.
1 The Sharpe Ratio calculations use a risk-free rate of 4% per annum.
2 Measured as the standard deviation of monthly returns.