Charting The Annus Horribilis

HFR’s Ken Heinz comments on some tough figures

Originally published in the February 2009 issue

The diffuse nature of the hedge fund industry makes for a heavy reliance on good data. While obviously the case for the various classes of investors, it is equally true for other players in the industry ranging from the prime brokers to administrators, not to mention regulators and central banks.

Hedge Fund Research, Inc., the Chicago-based data firm behind the HFR Indexes, has emerged as a key, publically-visible provider of information about the absolute return sector. It may not be quite the longest standing data provider – even though it was founded in 1990 – but HFR is clearly among the leading brands involved in disseminating data on hedge funds.

“Our firm is one of the longest standing data providers on the hedge fund industry,” says Kenneth Heinz, HFR’s president since December of 2006. “Our data reflects the landscape of the industry and we will continue to do that.”

The pressure facing hedge fund data providers has grown in recent quarters as the travails of fund managers and investment banks have come into sharp focus. Not only are record numbers of funds closing, but numerous firms are either seeking to delay reporting results, sometimes for legitimate technical reasons, but other times in order to shield manager sensitivities.

“In more challenging environments like now there is still demand for points of reference in terms of performance and capital flow data,” Heinz says. “Our interest is in trying to accurately show what the true landscape of the industry is in those areas.”

Clearly, there has never been more interest in the performance of hedge funds or more attention devoted to investment flows in and out of the sector. That, of course, correspondents with the massive growth seen across the industry for the half-decade through 2007, and the even more sudden contraction that has gained in intensity over the past six months.

“You are seeing a consolidation following two years of record growth in 2006 and 2007,” Heinz says. “Performance will improve when liquidity comes back into credit markets. As that happens, overall industry performance will improve and that will be followed by cash flowing back into funds.” Further, he expects consolidation among funds over the next three to six months to lead to improved liquidity for investors.

HFR has a standard process for investigating funds that quit reporting. An analyst from the firm contacts the manager to request a report and will make a qualitative assessment about why the report wasn’t filed. For the index itself, if a fund liquidates the performance data is not removed so guarding against the survivorship bias that would result if shuttered funds came out of the database.

In late January, HFR reported that the hedge fund industry recorded the most tumultuous year in its history with investors withdrawing a record $152 billion in capital during the fourth quarter of 2008. That took the whole year capital outflow to $155 billion compared with the record 2007 inflow into hedge funds of $194 billion.

However, the biggest source of the industry’s loss of assets was drawdowns. The HFRI Fund Weighted Composite Index fell 18.3% over the year, marking just the second calendar year decline since the firm began reporting data 19 years ago. Combined with redemptions it meant that assets under management fell $525 billion to $1.4 trillion at the end of 2008 from $1.93 trillion a year earlier.

HFR’s year end analysis found that investor redemptions were indiscriminate across fund strategies, regions, fund sizes and performance dynamics. The HFRI Macro Index rose 5% during the year, but macro funds still saw net redemptions of $31 billion. Among sub-strategies the HFRI Equity Hedge: Short Bias Index gained almost 29%, but nonethless experienced redemptions and fund liquidations in the second half of the year.

What’s more, dispersion among funds’ performance rose to record levels as shown in Figure 1. The top decile of all hedge funds gained an average of 40% whereas the bottom 10% of all funds declined an average of 62%. The HFRI Equity Hedge Index slid 26% for the year, performance that spurred $55 billion in capital redemptions from the strategy.


All this has left investor risk aversion at historically extreme levels. “People are looking, paradoxically, for risk free returns,” Heinz says. “Thus they purchase short dated government bonds. The low yields are difficult to believe,” he says, observing that returns are down to the levels seen in the 1940s. Heinz believes this represents a real risk to investors since such extreme risk aversion means investors could incur substantial losses. “I think there is a lot of risk in risk free securities. Not of default, but of things trading down substantially as yields rise. People may argue that the level of risk aversion may endure for some time. But most people would agree that risk aversion is cyclical.”

Aside from a thinly veiled warning about government bond markets, Heinz sees 2009 ushering in a far greater use of independent administrators. He notes that institutional investors will increasingly require it and will, like UBP, threaten to redeem allocations if independent administration is not adopted.

HFR data provides some scope for optimism about hedge fund returns. In the 12 months following the five largest historical declines, the sector has returned an average 15.9% compared with an average 11.1% annually since 1990. What may support this trend and be supportive of industry performance in 2009, Heinz says, is improving credit markets and an unprecedented level of global financial stimulus.