Introduction
Based on the information contained in the 2006 edition of the Eurekahedge North American Hedge Fund Directory1 and other related information, we currently estimate the total size of the North American hedge fund space at over 4,000 funds managing close to US$840 billion in assets. Operating in the world’s most advanced financial markets, these funds account for over three-fifths of the total assets parked in hedge funds globally. Historically too, the North American hedge fund universe has been sizeable (Figure 1); to put it in context, their size in 1997 is comparable to the current size of the Asian hedge fund space. However, the huge influx of money into hedge funds in the region meant a squeezing out of opportunities for significant absolute returns and the pace of growth of the industry has slackened in recent years, flowing into other regions, emerging or otherwise. The industry has witnessed an annualised asset growth rate of about 40% over the past decade. Contrast this with European hedge funds whose assets grew at the rate of 72% annually during the same period. Keeping these trends in mind, we estimate industry assets to reach US$870 billion by end-2006.
Figure 1: Industry Growth over the Years
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Source: Eurekahedge
This review seeks to provide a comprehensive overview of the current structure of the industry and some of the key trends that have shaped it over the past decade. To that end, this write-up examines the strategies, investment regions and other characteristics that make up the North American hedge fund space, then moves on to a comparative analysis of the performance of these funds vis-à-vis other modes of alternative investment, and finally takes a closer look at trends in the performance of North American funds and the factors that contribute to/affect such performance (such as size, strategic mandate, region of investment, performance fees, redemption preferences, etc).
Industry Make-up
This section further analyses the broad growth trend seen in the earlier figure into some of the salient aspects of the industry such as fund size, strategies employed, regions allocated to and so on.
I. Fund SizeComparing the distribution of funds among different fund sizes five years back and now (Figure 2), shows that while the trend of more smaller-cap funds has largely remained in place, a few interesting points emerge:
(1) New launches tended to be smaller in size. More specifically, the shifts in the funds-by-size distribution have, in the main, been from the large to the very small with little change in the shares of those in between. Between mid-2001 and now, funds with under US$50 million in assets accounted for over a half of the population, up from 45% five years ago, while those over US$200 million make up 22% of the funds (down from 30% five years ago). The fraction of funds in the US$50-200 million bracket has remained the same at slightly over a quarter of the total.
(2) However, the average size of a North American hedge fund has progressively gone up from US$77 million at the end of 2000 to almost US$200 million currently, implying a much higher rate of growth in total assets (35% annualised) than in the total number of funds (14% annualised) over the past five years.
Figure 2: Change in Number of Funds by Size in the Last Five Years
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Source: Eurekahedge
Another way of looking at the trends seen in the earlier figure is by comparing the initial and current assets under management (AUM) of all funds launched in the past decade (Figure 3). As can be seen, older funds have seen greater asset inflows, even at the expense of the more recently launched funds. Not only were the newer funds operating in an environment of shrinking opportunities, but they were also smaller in size (as the changes in the distribution of funds in Figure 2 suggests) and later entrants to the trend of diversifying into other regions of investment.
Figure 3: Asset Growth by Year of Launch
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Source: Eurekahedge
In terms of strategies employed, while the majority (over two-fifths) of the funds are equity long/short funds, with CTAs, arbitrageurs and multi-strategy funds making up another 10% each, the distribution of assets tells a slightly different story.
Figure 4: Breakdown of AUM |
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Source: Eurekahedge
Multi-strategy funds currently enjoy the highest average asset size (about US$390 million), with 9% of the funds accounting for almost double that share in total assets. Global macro funds are a close second with average assets of US$365 million, and opportunistic players such as event-driven and distressed debt funds have similarly high average asset sizes.
Examining this trend over time, Figure 6 compares the AUM shares of each of these strategies over the past five years and for the first half of 2006 (with long/short equities making up the remainder of the 100% for each of the years). This figure further supports the aforementioned trend, with more assets flowing out of equity long/short strategies (down from a 40% share to 30% share over the years) into fixed income, distressed debt and directional macro plays, while other pair-trading and arbitrage funds have seen little change.
Figure 6: Change in Strategy-Mix of Total AUM over the Years
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Source: Eurekahedge
In contrast, diversification across geographic mandates has been more broad based rather than country or region specific, as shown in Figure 72 below (with North America focused funds making up the remainder of the 100%). As can be seen, the majority of the funds continue to have global (41%3 ) or North America-centric allocations (50%), although there has been an increasing incidence of funds with a more regional/country focus (and in particular, emerging markets in Asia and Eastern Europe). Notably, the share of funds allocating to North America has gone down from nearly two-thirds to less than half of the total population, captured in turn by funds diversifying their geographical scope (global funds) or entering new markets.
Figure 7: Change in Geographical Mix of Total Fund Population
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Source: Eurekahedge
This trend is further supported by Figure 8, which compares the current average size of North American hedge funds by geographic mandate, as signified by the greater average size of funds focusing on emerging markets in general, and emerging Asia in particular, over that of North America-focused funds.
Figure 8: Average Fund Size (US$m) by Geographic Mandate
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Source: Eurekahedge
Having examined the size and structure of the North American hedge fund space, we now turn our attention towards mining trends of the performance of these funds. The aim is to answer two broad questions: – (1) how have North American hedge funds fared against other regional hedge funds as also other modes of alternative investment? (Section A); and (2) what factors/fund traits were responsible for the specific patterns of performance seen in North American hedge funds? (Section B).
A. Alternative Investments: Comparative Performance AnalysisIn this section, we compare the dispersion of returns across two dimensions – (1) mode of alternative investment; and (2) period of investment. The rationale for the former is to see how North American hedge funds have fared against their European (developed) and Asian (emerging) peers on one hand, and funds of hedge funds and long-only absolute return funds on the other. The rationale for the latter is to examine performance and performance dynamics across different and changing market conditions. 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 the past three months (May to July 2006) as well as the nine years before that, in blocks of three years. The severe market corrections and volatility seen in the past three months as markets were gripped by fears over inflation and a possible economic slowdown, offer a good avenue for examining the relative performance of various alternative investment vehicles. 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 past nine years afford an opportunity to study performance under both rising and falling markets. Furthermore, between the three 3-year blocks and the 3-month block, two cycles of alternately rising and falling markets are covered. Figure 9, comparing benchmark indices in the global bond, equity and commodity markets, makes this amply clear.
As may be noticed in the next section, we have used the same comparative models detailed above in analysing performance trends of North American hedge funds in terms of strategies, investment regions, performance fees charged, and so on.
Figure 9: Benchmark Index Performance Charts, May 1997 to July 2006
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Source: Eurekahedge
The following figure (Figure 10a) depicts the comparative dispersion of returns (of the middle 50% funds, ie tracing returns between the first quartile and the third quartile) over the past nine years, broken into three-year periods as described above. Several patterns emerge from this figure: (1) North American hedge funds have consistently outperformed their European peers as well as funds of funds; (2) they were the best performers in falling markets, outperforming even their long-only and emerging markets peers; (3) hedge funds allocating to the developed markets in general, proved far more resilient to tough markets than their emerging market peers (at least 75% of the funds in the former group generated positive returns during May-2000 to April-2003, while the bottom halves of both long-only funds and Asian hedge funds have had a noticeably higher percentage of negative returns-generating funds); (4) long-only absolute return funds, predictably, performed far better in rising markets; (5) Asian hedge funds tend to be long-biased owing to a relative dearth of shorting opportunities in the region, and are similar in their performance patterns to long-only funds.
Figure 10a: Quartile Dispersion of Returns by Mode of Alternative Investment
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Source: Eurekahedge
Figure 10b depicts a similar comparison of annualised returns for the most recentthree-month period of choppy markets, and the performance patterns are almost identical to those observed for the period between May 2000 and April 2003: North American funds were the best performing of the lot, with almost 50% of the funds closing the three-month period in positive territory and the top quartile funds even generating upwards of the equivalent of 10% annual returns. To be sure, this was as much the result of deeper and broader markets in North America, as it was of a flight of liquidity from riskier emerging market investments to quality.
Figure 10b: Quartile Dispersion of Returns by Mode of Alternative Investment
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Source: Eurekahedge
In this section, we narrow down our focus to the performance of North American hedge funds, and perform three layers of analysis;
- By key fund traits (each of the sub-sections below) that may have a bearing on performance – we examine performance across different fund sizes, strategies, regions of investment, performance fees and lastly, redemption preferences.
- By time period of investment (as detailed in the earlier section).
- By comparing mean annualised returns as well as the dispersion of these annualised returns (by quartiles).
We have used a sample set of 2,089 funds listed in the Eurekahedge North American Hedge Fund Database, with performance data going back to May 1997. Appendix 1 gives a tabulated summary of the quartile annualised returns of these funds broken down along the lines of points (a) and (b) above. In the following sub-sections, we compare mean returns with the dispersion of returns to draw insights about whether and how each fund trait has affected performance.
I. Fund SizeWhen looking at performance by assets under management, the generally observed trend is one of a direct relationship between asset size and performance (ie the bigger-sized funds tend to be better performing) until a certain optimal size is reached, at which point the relationship gets inverted (ie further additions to the fund’s assets bring total returns down), assuming other factors are kept constant. But the exact location of this optimal point on the fund-size spectrum seems to vary according to the type of hedge fund. For instance, in our performance reviews of Asian and European funds, both of which have witnessed significant growth only in the past 5-10 years, we have seen that the optimal asset-size point was higher for Asian funds (around US$1.5-2 billion) than their European peers (US$1 billion). This can be explained by the generally higher incidence of information asymmetries in Asia (as compared to Europe), and by extension, a lesser likelihood of a large-cap fund’s investment decisions influencing the markets.
Extending this reasoning to North American hedge funds would then explain the lack of any such clear trend of diminishing marginal returns, as can be seen in Figure 11. In fact, the largest-cap funds (>US$5 billion) registered the most solid gains during the up-trending markets between May 2003 and April 2006. This can be attributed to the increasing presence of global themes in the regional asset allocations of these funds, as noted elsewhere in this write-up.
That said, smaller-cap (and more nimble) funds tend to do better in tougher market conditions; for instance, funds in the US$100-200 million bracket posted the best returns (15%, annualised) between May 2000 and April 2003, while those in the US$500 million-US$1 billion bracket generated the best returns during the past three months.
Figure 11: Performance by Asset Size over Time
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Source: Eurekahedge
The inter-quartile dispersion of returns (Appendix 1) among various fund sizes further supports these findings – large-cap funds (>US$5 billion) performed far better in more recent rising markets. Comparing their performance between the periods May 1997 to April 2000 and May 2003 to April 2006, one can see that they had the highest median returns during the latter period (22.9% against 9.8% during the earlier period) as also a much higher inter-quartile range (18% to 27.7%).
On the flip side, during each of the periods of downward-trending markets, funds with assets between US$500 million and US$1 billion had the best median and top-quartile returns.
II. Investment StrategyIn terms of strategy employed, asset flows (noted elsewhere in this write-up) have, in the main, been in step with performance trends – Figure 12 shows, distressed debt, fixed income and multi-strategy funds, which now have a greater share of total industry assets than ten years ago, have all posted positive to healthy returns in recent years.
Another thing that stands out in the figure below is the superior performance of North American funds during May 2000 to April 2003, with most strategies returning upward of 10% on an annualised basis. This helps uncover the technical or style-based layer of the returns generated by these funds, compared with funds allocated to other regions or other modes of alternative investment (discussed in the previous section).
Figure 12: Performance by Fund Strategic Mandate over Time
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Source: Eurekahedge
Notably, distressed debt and multi-strategy funds consistently posted among the highest median and/or top-quartile returns during each of the periods in review, as a look at the quartile dispersion of their returns clearly shows.
III. Investment GeographyWe then compared the returns generated by North America-based hedge funds, broken down by the regions they allocate to (Figure 13), to help explain the performance of North American funds from a fundamental macroeconomic standpoint.
Setting aside the performance of the past three months for later review, the pattern of diminishing returns from North American allocations is an indicator of a squeezing out of opportunities in these markets. On the whole, average returns have gotten more equitable over the years across different allocations, with each region posting 7-8% annualised returns during the most recent 3-year period of up-trending markets.
A look at the quartile dispersion of returns shows that there is more to the above story, with top quartile returns (ie if all the funds surveyed were arranged in descending order of their annualised returns, the top 25% of the funds had returns at or above this figure) not only generally very high 6-9 years ago (upwards of 25% annualised), but also even better from allocations in previously underexplored markets in Asia, Latin America and Europe (top quartile annualised returns at 45% in the emerging markets and 52% in Europe). This trend has over the years slowly reverted to more normal levels top quartile returns for regional allocations.
Figure 13: Performance by Fund Geographic Mandate over Time
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Source: Eurekahedge
During the past three months (a period of sharp reversals and high volatility across asset classes), on the other hand, North American allocations have garnered the most stable (ie least negative) returns, a trend also seen in typical down-trending markets such as during 2000-2003. This had partly to do with an outflow of liquidity from and/or a redistribution of allocations to the emerging markets, to ‘safer’ assets. Understandably, these allocations were among the more adversely affected in terms of returns, during this period.
IV. Performance FeesWe then went on to examine other aspects of a fund that may have a bearing on performance, such as performance/incentive fees (covered in this section) and redemption preferences (covered in the next).
On a time series-based analysis of performance fees (broken down into three buckets – under 20%, 20% and above 20%) and performance, an interesting pattern emerged (Figure 14). Six to nine years ago, the relationship was curvilinear (inverted ‘U’), with funds charging 20% fees doing better than those charging under or over 20%. However, this relationship has become more linear over the years, with funds charging higher fees also generating higher returns to show for them.
Figure 14: Performance by Incentive Fees Charged over Time
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Source: Eurekahedge
Lastly, we reviewed the relationship between fund performance and the frequency at which funds allow their investors to redeem their assets. Of the 2,033 funds we surveyed, the majority had either a monthly (42%) or a quarterly (43%) redemption frequency, with the rest scattered across daily/weekly (6%), semi-annual (3%) and annual (5%) redemptions. We then plotted the performance across different time-periods of funds with the above redemption preferences, as depicted in Figure 15.
Figure 15: Performance by Funds’ Redemption Preferences over Time
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Source: Eurekahedge
In this case, however, no clear pattern emerged that can otherwise not be explained by strategic choices or fundamental factors. As can be seen from the figure above, there have been instances of flat as well as upward/downward sloping curves.
ConclusionTo summarise, the North American hedge fund universe still accounts for a sizeable portion (60%) of global hedge fund assets, and over the years, it has taken on the aspect of too many funds chasing too few opportunities. This has fuelled the need for these as well as start-up funds to spread their search for investment avenues wider, across investment strategies (increased activity in debt-focused, opportunistic and macro funds) and into markets in Asia, Latin America and Europe (increased global allocations). In the process, the average fund size has nearly doubled to the current US$200 million.
In terms of performance, North American funds continue to offer consistent and stable, if not superior, returns (as compared to other regional hedge funds, and long-only funds). Most strategies and regional allocations have returned between 5% and 10% on an annualised basis, in recent years. Also, asset flows into these strategies/regions have largely been in step with performance, with global allocations and opportunistic funds seeing improved returns. The size of the fund was another factor that helped explain the returns generated by these funds, with larger-cap funds getting the most mileage out of their global allocations during tough markets. We also noticed that the industry has become more efficient in ‘pricing’ its performance, with the better-performing funds charging higher incentive fees in recent years.
Looking at the current macroeconomic situation, the progressively improving month-on-month returns and indications that the Federal Reserve has finished raising rates, suggest that the market correction of the past three months appears to be on course to correcting back. The question now on the minds of global economic policy-makers is whether a slowdown in the US economy (the housing market has been cooling down and the unemployment rate has been inching up) is enough to allay inflation concerns without the Fed having to resort to further rate hikes. The basic forecast of slower growth, but no recession, has a good chance of coming true, and should lend a sense of stability to the markets in the coming months.
In the specific context of hedge fund performance, as the US economy slows down and the Fed takes a pause, company fundamentals will become more important and should lead to clear winners and losers. Hedge fund portfolios are poised to benefit from falling US and global treasury yields, rising energy prices, strong deal flows and weaker equity prices.
Appendix 1: Quartile Dispersion of Annualised Returns across Time Periods and Fund Traits
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Footnote
1 The online database captures information on 2,505 hedge funds that currently allocate to and/or are managed out of North America, in addition to another 325 obsolete funds.
2 In contrast with Figure 6, this figure compares changes in the number mix as a proxy for changes in asset mix, so as not to let the very large values (of global and North American allocations) drown out the smaller ones (of emerging markets and European allocations).
3 Based on trends observed in a sample of 1,668 North American hedge funds.
