Hedge funds recover and evolve

Hedge funds have bounced back strongly from their lows last year, but they seem to recognise the need to adapt to their new environment.

Despite recording their strongest gains since 1999, hedge funds are still below their peak performance level in 2007, says Chicago-based Hedge Funds Research Inc (HFRI). And they are showing signs of altering their approach, with a shift towards greater flexibility and transparency, adds the firm.

Inclusive of 2009 gains of 20.1%, the HFRI Fund Weighted Composite Index still remains 4.5% below the peak performance level set in October 2007. Not all funds have shared equally in the recovery; around 2,000 funds have liquidated since the inception of the financial crisis, while just over half of all funds have returned to their respective high-watermark levels in 2009.

The HFRI Fund Weighted Composite Index posted its worst calendar-year loss in the history of the industry in 2008 of -19.03%.

Looking at individual strategies, the HFRI Fixed Income Convertible Arbitrage Index came out top for 2009, with a 60.18% return, almost recovering the losses suffered in 2008, when it fell 33.73%. The runner-up was the HFRI Emerging Markets: Russia/Eastern Europe Index, with a 51.80% gain, having posted a 59.44% loss the previous year. The HFRI Emerging Markets: Asia ex-Japan Index rose 37.55% last year, after falling 33.48% in 2008.

Meanwhile, HFRI reported a fall in the number of hedge funds to 9,050 at the end of last year from 9,284 at the end of 2008. That's a smaller drop than the one the previous year -- 10,096 funds had been in operation at the end of 2007.

As for inflows, investors allocated $13.8 billion of new capital to the industry in the fourth quarter of 2009, the largest quarterly inflow since the first quarter of 2008. But that increase had only a modest impact on full-year capital flows, with investors withdrawing a net $131 billion overall in 2009.

Strong performance more than compensated for investor redemptions, however, bringing overall global hedge fund assets up to $1.6 trillion by the end of 2009. That is nearly $260 billion higher than the low in the first quarter, but still $330 billion below the peak of $1.93 trillion set in the second quarter of 2008.

As regulators globally focus efforts on the hedge fund industry, private markets have already evolved offerings to meet new investor demands. In contrast to the traditional 2% management fee/20% performance fee model, average management and performance fees are now 1.6% and 19.2%, respectively.

Many funds that historically required investors to lock up capital now offer products with no lock-up, while others have offered products with lower fees or hurdle rates in consideration for capital or term commitments, says HFRI. While standards such as Ucits III have achieved wide and growing acceptance, nearly all funds are now open to transparent fund investment; transparency has become the institutional standard.

"In many respects, hedge fund performance in 2009 suggests an aggressive return of risk -- essentially the reverse of the financial crisis of 2008 -- but this generalisation masks a significant evolution of the industry which has occurred," says Kenneth Heinz, president of HFRI. "Many of the fund strategies that were most out of favour in 2008 became top performers in 2009."

"At the same time," he adds, "funds have responded to investor demands by offering more specialised exposures, modified terms and greater transparency than pre-2008."

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