The Difference between the Best and Worst Hedge Funds? Less than You Think

Top hedge funds are only outperforming the worst ones by 21.5%, according to data from HFR.

(January 22, 2014) — The difference between the average performance of the top and bottom decile hedge funds has drastically shrunk over the past three years, according to data from Hedge Fund Research (HFR).

Unveiling its Global Hedge Fund Industry report for 2013 to journalists yesterday, HFR President Kenneth Heinz noted that the spread of average returns produced by the bottom and top performing hedge funds had narrowed since the financial crisis, with a particular contraction evident since 2010.

The largest spread since 2000 was shown in 2009, when the top 10% of hedge funds returned an average of 99.96%, compared to the bottom ranking 10% of hedge funds which lost 16.48% on average.

Another large spread was evident in 2008, when the top performing hedge funds returned an average of 40.97%, while the worst 10% of hedge funds lost 62.39%.

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But since 2010, these spreads have reduced: That year the top performers returned 43.24% compared to the worst performers losing 14.63%, a spread of 57.87%.

The spread narrowed further in 2011, as the best hedge funds returned an average of 19.51%, compared to a loss of 30.66% from the worst performers—a spread of 50.17%. The spread narrowed again to 48.63% in 2012.

And for the first three-quarters of 2013, the top decile performers returned an average of 39.69%, while the worst performers returned an average of 28.13%.

Heinz put the narrowing of dispersion between the top and bottom hedge funds down to muted performance in macro strategies, the uncertainty of the European financial crisis, and the unprecedented activity of interest rate depression and the boost to liquidity provided by monetary policy measures.

“In effect, the carry opportunities aren’t there anymore,” Heinz added. Carry is the name given to the return opportunities or the cost for holding an asset.

Other highlights from the HFR report included that a surge of interest in event driven strategies—those that attempt to take advantage of events, such as mergers and restructurings, that can result in the short-term mispricing of a company’s stock—helped flows into hedge funds increase to $2.63 trillion in the fourth quarter of 2013.

Event driven strategies led capital inflows across all strategies for the first time since 2007, growing by $140 billion to more than $698 billion for 2013.

Capital invested in equity strategies also experienced a strong final quarter of the year, increasing by $48 billion thanks to investor inflows of $8.6 billion. Total assets in fixed income-based relative value arbitrage strategies also increased by $18 billion to $684 billion for the quarter.

The vast majority of money went to hedge funds located in the North American region, with 71.6% of 2013 capital flows heading to the continent. European hedge funds received 22.3% of flows, while Asian-domiciled hedge funds took just 5.8%.

“Hedge fund industry growth has continued to a record level of assets despite the challenges presented by a transitional regulatory environment, strong gains in traditional equities, and uncertain macroeconomic and political environments in 2013,” said Heinz.

“With the US Federal Reserve beginning the process of tapering stimulus measures and economic pressures receding across the EU, the combined normalisation of interest rates, equity market valuations, and investor risk tolerance is likely to contribute to a conducive environment for actively managed, long-short investing as investors hedge 2013 beta-driven gains in favour of differentiated, uncorrelated alpha in the coming years.”

The full report can be found here.

Related Content: Women-led Hedge Funds Beat Out Male Peers, Again and Where Were the Best-Performing Hedge Funds in 2013?

Investment Outposts: A Guide to Branching Out

Sovereign funds and pensions have launched satellite offices to foster in-house management, reduce agency problems, and spot new opportunities, according to a paper.

(January 21, 2014) — As pension plans and sovereign wealth funds take on more active roles in the investment process, they’re increasingly looking to expand geographically closer to the financial centers of the world, according to a study.

It’s about “getting closer to the action,” wrote Qais Al-Kharusi of the State General Reserve Fund of Oman, Adam Dixon of the University of Bristol, and Ashby Monk of Stanford University in a paper. “In large part, this is an attempt to better align interests across the investment production chain and re-root finance and investment back in the real economy.”

As the more removed and “frontier” funds continuously seek to diversify risk exposures and capture alpha—largely from new asset categories—they have become motivated to open satellite offices in international financial centers (IFC) and non-financial centers (NFC), the researchers wrote.

IFCs are locations such as New York, London, Hong Kong, and Singapore. NFCs, according to the paper, include Beijing, Chennai, São Paulo, and San Francisco, among other metropolises.

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“This increased involvement of these investors can be described as an attempt to reduce the agency problems that are pervasive in the functional and spatial structure of the investment management industry,” the authors said.

From these locations, investors aim to rely less on external managers and garner crucial local expertise. Lower management costs and increased investment opportunities could also entice investors to open more offices.

“The hope, then, among these beneficiary institutions is that the adoption of new models of institutional investment will result in better long-term performance,” Al-Kharusi, Dixon, and Monk said.

With an investment staff in the same location as the opportunities, investors stand to benefit from natural face-to-face interaction with on-site managers, and the trusting relationships it can foster. This, the authors found, would be especially useful in regions where “informational asymmetries” persist.

“A key factor underpinning the success of these funds’ new strategies will be the collection of data, the processing of information, and the formulation of knowledge upon which investment decisions can be based,” the study said.

Institutions have been compelled to open IFC outposts for access to deeper talent pools, improved monitoring and due diligence capacity for new managers, stronger network formation, smoother knowledge transfers, and quick facilitations of co-investment opportunities, the paper noted.

The expansion is not without challenges, according to the authors. Investors should take into account opening costs, possible culture and governance clash between the main and satellite offices, and potential loss of talent.

“The non-local offices can become a revolving door for staff; a sort of holding tank for individuals before they move back to the private sector opportunities,” the researchers said.

For a foreign fund, establishing an NFC office could improve access to local knowledge and foster closer relationships with the regional government and local power networks.

The biggest challenge in setting up a satellite in an NFC is scalability, according to the paper.

“Many NFCs in emerging markets, while growing, have a long way to go before offering the depth of market that is found in more advanced economies. The initial setup and ongoing operating costs of the satellite office need to be weighed against the scale of investment opportunities,” the authors said.

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