Introduction

The total size of the North American hedge fund space is estimated at nearly 4,800 funds managing close to US$1.1 trillion in assets¹; operating in the world’s most advanced financial markets, these funds account for nearly two-thirds of the US$1.8 trillion parked in hedge funds globally. Historically too, the North American hedge fund universe has been sizeable (refer Figure 1); to put it in context, their combined size in 2,000 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 somewhat slackened in recent years, flowing into other regions, emerging or otherwise. The industry has witnessed an annualised asset growth rate of approximately 20% over the past six years. Contrast this with European hedge funds whose assets grew at the rate of over 50% annually during the same period. Keeping these trends in mind, we estimate assets to breach the US$1.1 trillion mark by end-2008.

Figure 1: Industry Growth over the Years

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Source: Eurekahedge

In this write-up, we review recent trends in the size, structure, growth and performance of North American hedge funds, drawing comparisons where applicable to other absolute return funds. To this end, the review is organised to give an overview of various aspects of the current structure of the industry (distribution of funds across strategies, regions of investment, asset ranges, fee components etc, and recent changes therein), and also a closer inspection of the performance trends shaping this particular space.

Industry Structure and Trends

Size
The hedge fund universe in North America, if not globally, is currently at a ‘high-turnover’ stage of its industry lifecycle, with many firms entering as well as leaving the market. Furthermore, the rate at which a fund absorbs assets typically depends on the strategy employed, the timing of the investments, as well as a broad ‘optimal’ size that allows a fund to remain nimble in a dynamic market environment. Taken together, these factors have led to a sustained negative skew in the distribution of funds by size, as is evident from Figure 2 below; nearly three-fifths of the funds surveyed have assets under US$50 million each, while a mere 4% of the funds manage assets in excess of US$1 billion.

Figure 2: Distribution of Funds by AuM (in US$ million and %)

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Source: Eurekahedge

On the other hand, average fund size has been steadily on the rise, almost doubling from the US$121 million in 2003 to the current US$230 million, as stable returns for most of the period in question have helped funds progressively outgrow their initial AuM ranges. This transition over the past five years is captured in Figure 3 below. As is evident, middle-order fund sizes (US$100 million and above) have registered noticeable increases in the number of funds, shoring up fund size averages.

Figure 3: Change in Distribution of Funds by Size in the Last 5 Years

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Source: Eurekahedge

Strategy
In terms of hedge fund strategies employed, figures 4 and 5 detail the current breakdown of funds and assets managed. A comparison of these two figures hints at the strategy-wise direction of asset flows in recent years; apart from strategies with a global mandate such as macro and multi-strategy, opportunistic trading strategies in North America currently enjoy the largest mean fund sizes (US$394 million on average) – this is mostly in the event-driven space, however, as distressed debt and high yield managers have been hit by the recent turmoil in the US credit markets. These are followed by arbitrageurs (some of which also include opportunistic strategies such as merger arbitrage and capital structure arbitrage) and currently manage US$379 million in assets on average.

Figure 4: Distribution of Assets by Strategy Employed

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Source: Eurekahedge

Figure 5: Distribution of Funds by Strategy Employed

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Source: Eurekahedge

Geographic Mandate
In contrast, diversification across geographic mandates (of North America-located funds) has been more broad-based rather than country- or region- specific, as shown in Figure 6 below. Although the majority of the funds continue to have global (53%) or North America (39%) –centric allocations, there has been an increasing incidence of funds with a more regional/country focus (and in particular, emerging markets in Asia and Eastern Europe, as is evident from Figure 6). Notably, growth in European and North American allocations was significant in 2004 and earlier, while emerging market assets have seen healthier growth in recent years. It must also be noted that location has a bearing on the superior growth in Latin American allocations (as opposed to Asia ex-Japan allocations). That said, global fund managers have been increasing their presence in emerging markets in general, and Asia in particular, in recent years. This trend of expanding emerging market asset shares is further supported by Figure 6, which compares the current average size (in US$ million) of North America-based hedge funds by geographic mandate, as signified by the greater average size of funds focusing on Latin America and emerging Asia, over that of North America-focused funds.

Figure 6: Average Fund Size (US$ million) by Geographic Mandate

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Source: Eurekahedge

Incentive Fees
There is a certain demand-supply dynamic at play in an industry that is witnessing many firms enter and leave the market. We set out to examine whether this has had an upward or downward pressure on overall hedge fund incentive fees. In order to do so, we compared the weighted average incentive fees charged by hedge funds of different ages on the one hand, and in the other – new hedge fund launch activity over the past 15 years (Figure 7). Adjusting for short-term highs and lows from year to year, it is interesting to note that there has been a perceivable shift in the trend of average fees charged over the last year or so. That is to say, similar surveys in previous years have suggested that average incentive fees are on the decline, ie newly set up funds tend to charge lower fees. Notably, in the last seven years, a marked increase in the number of start-ups has had the effect of initially steep, then flattening, fee rates. But with market volatility on the rise, the demand for skilled managers that can deliver superior returns is being particularly felt, and this is evident in the rising average fees of funds launched in the last 12-18 months.

Figure 7: Start-up Activity v/s Fees Charged

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Source: Eurekahedge

Looking at the same graph from a different perspective, older funds distinguish themselves from more recent entrants with their longer track records, and hence, can command higher fees. A comparison of average hedge fund size by fees charged also supports this. Although average fund size is on the rise (billion-dollar launches are no longer unheard of), hedge funds have traditionally started on a smaller scale (over a third of the hedge funds surveyed had assets under US$20 million each, whereas funds with over US$1 billion in assets accounted for a mere 5%) and tend to have an optimum size beyond which returns begin to diminish. So, on a comparison of average fund size and fees charged, we observed that the two share a direct relationship; funds that are larger in size, can conceivably attract capital through either superior trading strategies or longer track records or both, and hence can afford to charge higher fees.

Performance
North American hedge funds have traditionally offered very stable returns (annualised returns of 12% over the last seven years, and a Sharpe ratio of 1.5, on average). But how do these returns compare against those in the underlying asset classes?

In an attempt to very roughly estimate the alpha generated by North American hedge funds, we constructed a hypothetical benchmark index of equities, bonds and commodities – by a) combining three broad US market indices via the S&P 500 equity Index, the Dow Jones Corporate Bond Index and the Reuters/Jefferies-CRB commodity Index); and b) assigning weights ² approximately equal to the AuM shares for hedge fund strategies in these respective asset classes (refer Figure 4).

We then compared the performance of the resultant benchmark index with that of the Eurekahedge North American Hedge Fund Index for the past three years (up to May-08), depicted graphically in Figure 8 below. The hedge fund index had a Beta of 0.72 with respect to the broad market index. At an assumed risk-free rate of 4% per annum, this translates into a Jensen’s alpha of 6.7% (on an annualised basis) for the portfolio of North American hedge funds.

Figure 8: Market v/s NAHF Index Comparison Chart

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Source: Eurekahedge

The following section takes a closer look at how returns across various industry participants are dispersed, and what, if any, is the impact of factors such as size and strategy employed, on performance.

Dispersion of Returns
Table 1 below compares the quartile dispersion of returns (annualised as well as risk-adjusted, over the past three years) across various modes of alternative investment such as long-only absolute return funds (ARFs) and funds of hedge funds (FoFs), and also regional hedge fund vehicles in Latin America, Europe and Asia³.

While the data supports what has been said earlier about the superior performance of fund allocations in the emerging markets, it is notable that median and upper quartile returns in North American hedge fund allocations are comparable to those in Asia and Europe, and have out-performed fund of funds returns. Returns from long-only strategies, and to a lesser extent from Latin American allocations, were assisted by strong bullish sentiment and upward trending markets during the period in question. This is apparent from a comparison of the returns generated by ARFs and North American hedge funds during periods of market volatility/corrections; for instance, in May/June 2006, the former lost as much as 6% on average while the latter were down less than 1%; another similar case was during the market downturn in July/August 2007. The dispersion of risk-adjusted returns among the various fund types in Table 1, further illustrates the above: the Sharpe ratios of North American allocations are on par with those in Asia and Europe as well as with those in ARFs and FoFs.

Table 1: Dispersion of Returns across Various Alternative Investment Vehicles

Source: Eurekahedge

A similar but closer comparison between hedge funds in North America (Appendix I) and elsewhere (Appendix II), varying for size of the fund, strategy employed, and fees charged, follows:

In terms of fund size, larger funds in North America have fared better than those elsewhere, while smaller funds performed better in non-US markets; for instance, 25% of the North American funds with assets in excess of US$2 billion, returned upwards of 20%, while elsewhere third quartile returns for that size bracket were about 18%. This suggests the relative advantages of leverage and diversification, when operating in more efficient markets.

Nearly 90% of the funds surveyed charge an incentive fee of 20%, so it is understandable that return dispersions vary so widely between funds with atypical fee structures. But among the ‘20% fee’ funds, particularly in the top two quartiles, those allocating to non-US markets enjoyed better returns over the last three years than their North American counterparts. As illustrated in an earlier section on fees, this is owing to the higher average age and longer track record of the latter.

Return spreads across strategies also show a similar pattern of slightly better returns among non-US funds, with significant variations justified by the performance of respective underlying markets. For instance, multi-strategy allocations to North America and elsewhere showed the widest gap over the last three years, with median returns at 9.4% and 13% respectively, and upper quartile returns at 12.2% and 17.6% respectively.

In Closing

The North American hedge fund universe is a mature space commanding sizeable assets (still accounting for over half of global hedge fund assets), offering stable returns and keeping pace with the evolving hedge fund scene in terms of expanding into newer markets and opportunity sets; the share of emerging market allocations of assets with US-based managers has nearly doubled over the last year, growing from 4% two years ago to the current 6%. Asset growth rates in recent years have also been higher in developing market and/or opportunistic allocations.

In terms of performance, North American funds continue to offer consistent (relative to other regional hedge funds) and solid (in absolute terms) returns; on average, allocations in the region have returned upwards of 11% per annum over the past three years. We also noticed that North American funds with a large asset base (> US$2 billion) have fared arguably better than their counterparts elsewhere, getting the most mileage out of their global allocations.

Looking ahead, after the turbulent markets over the past several months – as concerns over distress in the credit markets grew and spilled over into other asset classes in August 2007, sending risk aversion, volatility and borrowing costs up – we remain optimistic about the outlook for hedge fund performance in the latter half of 2008. Equities are currently extremely oversold opening up opportunities on the short side for bottom-trawling long/short managers. Secondly, value traders and arbitrageurs are re-allocating to short-term trading strategies in light of heightened market volatility; this is already being reflected in their returns distributions with North American managers faring slightly better than their peers elsewhere (median returns among value traders were 8.4% in North America and 8% elsewhere, while upper quartile returns were 13.6% and 12.3% respectively). Thirdly, managed futures funds have had a terrific spell over the past several months, largely owing to clear trends in the energy and currency markets (North American CTAs returned 16% on average in the first half of 2008 alone). Furthermore, upward pressure on energy prices is expected to persist, owing to declining inventories and rising geo-political tensions in the Middle East.

Appendix 1

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Source: Eurekahedge

Appendix 2

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Source: Eurekahedge

 

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