Summary
• Q309 results confirm the hedge fund industry in general is en route to its best performance since 1999. Major trends that benefit hedge funds and funds of hedge funds (FoHFs), include rising equities, lower credit spreads, and improved liquidity.
• Total hedge fund assets bottomed out globally in Q109, but Q209 and Q309 witnessed net positive client subscriptions. The situation is less favourable for FoHFs, which continue to suffer from net redemptions.
• Top-down macro positioning has been a dominant factor in terms of performance generation. Pure market-neutral strategies are less convincing. Convertible bond arbitrage and emerging markets strategies are clear winners in the alternative investments universe to date and market exposure is key.
• Hedge funds are progressing back towards directional trading; however, the risk remains that macroeconomic concerns thwart this impulse.
• Fitch notes the growing importance of top-down inputs and resources in FoHF portfolio management.
• The investing public is concerned that FoHFs continue to underperform single-manager hedge funds; however, Fitch believes FoHFs may have different risk/return objectives and in this study tries to shed some light on 2009 figures.
• In search for marketability, transparency and liquidity, FoHF managers are currently launching UCITS vehicles.

Performance review of funds of hedge funds
Q309 results are demonstrating hedge funds and FoHFs globally are en route to their best annual performance since 1999, while global assets under management bottomed out in the first quarter of the year (see Fig.1 and Table 1).

Several data providers (HFR, HFN.net, Eurekahedge) reported net gains in client money flows from May 2009, continuing into Q309. However, breaking down the figures for FoHFs leaves a more balanced picture. HFN reported net client redemptions in FoHFs were still evident in Q209, and these were not compensated for by their positive performance. In these conditions, concern remains as to whether FoHFs, as alternative investments vehicles, can continue to channel 50% of the global assets invested in hedge funds (as has been the case in the last 10 years). Meanwhile, a number of large institutional investors are considering – and some have already done so – bringing their hedge fund selection back in-house (insourcing), though raising the share of strategic asset allocation devoted to alternative investments.

However, despite a visible upturn in performance, it is the economics and business model of hedge funds that are still at risk in the current environment, at least for the weakest firms. Market commentators have noted the interesting status of hedge funds’ high water marks, which heavily impact a fund’s capacity to generate revenues and profits. Examining the 1,100 largest hedge funds tracked by BarclayHedge data provider as at April 2009, TrimTabs research practice provided the data shown in Table 2. From these numbers, it appears many hedge funds will indeed experience difficulties in maintaining appropriate revenue and profit levels that normally would be used to invest in new technology, hire and keep quality professionals or even save cash for more adverse market situations. Again, one can easily see how such a situation may trigger forced consolidation in the industry and a year of good performance will not change the situation.

As at the end of June 2009, HFN reported global hedge fund assets stood at $1.79 trillion (44% of which through FoHFs); this represents an overall drop of 40% as compared to the historical peak observed in Q208, when FoHFs controlled almost 50% of hedge fund assets.

Although not necessarily a positive factor, the fundamental dilemmas of the current macroeconomic context have at least been made clearer. The “inflation or deflation” puzzle remains a hot topic, notably because it is still unclear as to whether the observed health in global markets (equities, bonds) is a simple and technical reaction to massive government stimulus and inventory adjustments, or if the world economy has genuinely entered a new period of growth. As a result, from March onwards, the effect has been:

• equity markets have demonstrated unprecedented recovery (about +50% in developed markets since the trough in March 2009);
• the US treasury yield curve has shown decisive signs of steepening;
• corporate bond spreads (swaps and cash) have been falling;
• the spread between US T-Bills and LIBOR dollar short-term rates has fallen to levels not seen since early 2007;
• commodity prices are timidly back on a rising trend.

However, fundamental “real economy” indicators are still depressed:

• unemployment continues to rise (though at a slowing pace), which should put pressure on consumption;
• lending activity is still feeble;
• generally, the historically high indebtedness levels of governments has decreased their capacity to act and support the economy;
• industrial over-capacity is patent and may weigh on recovery measures.

This analysis helps understand the trends experienced in the hedge fund industry in the last two quarters.

How do the new macro conditions affect FoHF top down processes?
Most FoHF managers claim they provide manager selection and monitoring services, together with macro/strategy allocation capabilities. All three aspects have been particularly critical in the last two years. Some FoHFs have suffered heavily from wrongly selected or poorly monitored hedge funds (either fraud-related like Madoff or wrongly positioned hedge funds); however, top-down processes have also failed in many instances, with some FoHF over-exposed to risky assets from the outset of the crisis (particularly bubble-like asset classes sensitive to deleveraging, e.g. commodities, emerging, credit, and asset-based lending).

Historically, top-down processes in FoHF have taken different shapes but their purpose was often more “marketing” than practical. Furthermore, the cost of top-down errors has been generally quite limited over the last decade, given the moderate dispersion of returns between hedge fund strategies.

After two years where risk management and monitoring have played a key role, it is Fitch’s conviction that top-down resources and processes will be key differentiating factors among managers in the future. Fitch recently reinforced this belief when it updated its asset manager rating criteria (see report Reviewing and Rating Asset Managers, 18th June 2009).

What is changing in the macro picture?
Without wishing to make any long-term macro forecasts, it is worth considering the likely changes in a macro context, and how they will affect the way FoHF top-down processes operate.

First and foremost, the degree of uncertainty as regards markets is expected to be much higher than it was in the years 2003 to 2007. This means that the various measures of volatility are likely to exhibit much higher values; furthermore, capital markets are likely to be characterised by more frequent regime shifts; in other words, reversals of fortune at the asset class, strategy, or hedge fund level will be more frequent and therefore, will dramatically increase the cost of overreaction.

Such rising uncertainty can be attributed to the current large macro changes; these are likely to lead to increased volatility before “normal” service is resumed. It is Fitch’s belief that investors in FoHFs should not hesitate to challenge the managers they work with on each of these issues.

What secular trends still exist?
• Rapid capital flows and asset bubbles: Capital markets continue to be fuelled by global flows, massive amounts of liquidity in dire need of yields to meet liabilities (pension funds, insurance companies, individuals, etc.) and rapid circulation of information. This will continue to fuel market correlation (between markets), autocorrelation (momentum phenomena) and self-fulfilling prophecies that ultimately result in frequent asset bubbles. While asset bubbles are not new in financial markets, recent examples are particularly striking.

• Emergence of new pools of capital: Sovereign wealth funds, excess reserves, hedge funds, and private equity – which together accounted for approximately 15%-20% of total assets under management pre-crisis – are expected to remain important investors over coming years. Their allocation decisions will continue to play crucial roles in the pricing dynamics of capital markets.

• Globalisation of market capitalisation: There is no evidence to suggest a halt in the secular evolution towards a more evenly distributed market capitalisation. In 2009 – for the first time in history – Asia, LatAm, and other developing countries accounted for more than North America in terms of exchanges’ market capitalisation, according to the World Federation of Exchanges.

What does all this imply for top-down processes?
The current market environment – and that of coming years – is likely to make top-down decisions particularly challenging and critical. Changes are likely to be required at the top-down level and as regards allocation processes; these may be particularly challenging for those managers who have grown comfortable with current practices. Fitch expects FoHF management platforms will have to overcome numerous hurdles. Fitch has already noted a strengthening of the top-down process among certain FoHF managers. This involves, for example, the creation of a macroeconomic advising committee, the recruitment of investment analysts with a top-down focus, and the development of comprehensive top-down quantitative models to capture market and economic dynamics.

FoHFs’ underperformance relative to single-manager hedge funds in 2009: putting it into perspective
A subject that becomes more and more of a concern among the investing public is the underperformance of FoHF indices in 2009 when compared to their single-manager peers. Even a cursory glance at mainstream global hedge fund indices is sufficient to conclude that FoHFs are behind the curve this year. Broadly speaking, multi-manager FoHFs had a six to eight percentage point lag over single managers, as at the end of the third quarter.

In current circumstances that could become a problem, because FoHFs have clearly emerged as one of the most criticised investment mediums following the worst period ever in alternative investment history, H208. Historically hailed as providers of stable, secure and uncorrelated long-term returns, the FoHF sector partially failed in 2008, in several regards:

• many such funds were in fact hugely sensitive to equity markets;
• the supposed superiority of investments, thanks to in-depth due diligence research, proved flawed, following a series of hedge fund blow-ups and frauds;
• the very viability of the business model was put into question following the impact of asset/liability imbalances and liquidity mismatches; and
• their performance failed to reap the rewards of the promised diversification mitigation factor.

In other words, the underperformance of FoHFs in 2009 is casting doubt on their ability to maintain (or regain) their prime position as a convenient and efficient provider of alternative beta/exposure for institutional investors lacking the research resources, competence or simply the necessary time for venturing into alternative investments. The current consensus in the industry suggests that institutional investors around the world are actually raising the share of strategic asset allocation dedicated to alternative investments (hedge funds, real estate, infrastructure, commodities); as such, significant market share is at stake.

However, this simple observation of index return differences harbours two major shortcomings:

• As HedgeFund.net (HFN) has noted in recent research – based on its own database of hedge funds and FoHFs – single-manager hedge fund indices are much more exposed to the well known survivorship bias than FoHF indices. Although it is difficult to put precise figures on the exact degree of fund attrition (or funds still referenced but no longer reporting), it is apparent that FoHFs generally last longer as investment vehicles than single-managers. This means FoHFs are dragging badly performing single-hedge funds which, in turn, may no longer even be reflected in single hedge fund indices. A potential conclusion could be that FoHF indices may be a better indicator of the overall health of the hedge fund sector, less biased, and longer-term oriented.

• Another observation – clearly demonstrated by events this year – is the shear level of cash held by portfolio managers. Again, this is not new to 2009. Because of the intrinsically less liquid nature of FoHFs (they are dependant on the liquidity schedules of their own underlying investments), it is reasonable to accept that FoHFs will carry more cash on their balance sheet than single-hedge funds, a situation exacerbated by the events of 2008-2009. This makes FoHFs less flexible in terms of their ability to react to positive market orientation (lower leverage, lower equity market beta), a fact apparent in 2009.

As a consequence, simply looking at market indices may be misleading; a more considered examination of the available data may help shed light on the reality of FoHF performance in 2009. Fitch has chosen two avenues in so doing:

• a historical comparison of index returns in order to establish whether the 2009 series has any materially distinct behaviour (index-based study);
• a point-in-time study of 2009 monthly returns, as compared to single-manager hedge fund strategies, for a select number of investment vehicles (vehicle-based cross sectional study).

Firstly, when looking at the major indices, FoHFs have generally always underperformed single-hedge funds in absolute terms. (Fitch charted the cumulative difference in returns since 1993 between FoHFs (HFRI FoHF Composite Index) and single-manager hedge funds (HFRI Fund Weighted Composite Index), and also isolated annual returns for both series and examined the return differential between both series).

It is interesting to observe that the largest single-year return differences occur at times of economic recovery following major financial shocks. That is, for reasons explained earlier, FoHFs tend to react with less sensitivity to positively oriented markets. From that angle, 2009 has been reasonably standard in terms of expected performance.

Continuing with the analysis of these two indices, it is also important to consider the different levels of risk that each series demonstrates, as measured by the annualised standard deviation of monthly returns. As discussed in previous newsletters, FoHFs are promoted as lower-risk and more stable investment vehicles than their single-manager peers.

The main observations are:

• almost yearly since 1993, FoHFs have demonstrated lower volatility than single-hedge funds;
• The return versus risk ratio of both series appears much less in favour of single-hedge funds than the absolute return differential. They are in fact equal to date in 2009.

As a second step, Fitch also analysed the returns of a select groups of FoHFs and single-manager hedge fund vehicles from a “micro” and cross-sectional standpoint. The objective was twofold:

• overcome the typical index construction-related biases;
• demonstrate FoHFs serve their stated purpose, i.e. purveyors of stable and reliable alternative beta (although they should not be viewed as competitors to single-manager hedge funds which clearly appeal to different kinds of investors and/or objectives).

This study was conducted using HFN’s fund database which, in mid-2009, provides data on north of 7,100 investment vehicles globally. The FoHF universe diverges from that of the single-manager hedge fund universe within the HFN database. Groups of vehicles which satisfied a pre-determined list of requirements – a minimum $250 million in client assets and at least five continuous years of operation – were identified, and specific statistics of performance and risk were determined for each series.

It is clear that long-standing FoHFs with a significant level of assets have been more numerous and shown less outliers than single-hedge funds. However, fewer vehicles were able to generate abnormally high performance figures, i.e. above the aggregate hedge fund index of HFN. The graphical distribution of FoHF and single-manager hedge fund vehicles according to their return range (YTD 2009) helps illustrate this concept (using only multi-strategy funds).

The below observations summarise Fitch’s findings:

• market indices are significantly biased (survivorship) and tend to favour single-strategy hedge funds;
• FoHF market indices may be a better and more consistent indicator of the true health of the hedge fund universe;
• FoHFs as an asset class have traditionally – and continue to – underperform single-strategy hedge funds in absolute terms. In this respect, 2009 is no different (in magnitude or timing) to any other year and tends to demonstrate that the intrinsic and fundamental nature of FoHFs induces a slower reaction to market orientation (particularly during periods of recovery);
• FoHFs have historically exhibited lower volatility than single-manager hedge funds;
• return figures for FoHFs are more in line with single-manager hedge funds when considering the effects of risk (volatility);
• in terms of strategic asset allocation, it is appropriate, convenient, and efficient to choose a long-standing and large FoHF, as opposed to cherry picking a single-strategy hedge fund vehicle. Obviously, this statement appeals rather to investors that do not actually have the necessary resources to devote to hedge fund selection.
• as investment vehicles, FoHFs are practical providers of stable exposures (beta) to alternative investments, as their returns exhibit less dispersion than single-manager hedge funds. However, the contra-side to this statement is that it is also reasonable to conclude that investors with the necessary qualifications, resources, time and inclination are more likely to yield abnormally high returns by conducting their own hedge fund selection, as opposed to relying on a FoHF manager.