Introduction
The Eurekahedge Global Fund of Funds Database contains information on 1,975 funds of funds. Based on this and related information, we estimate the total size of the fund of funds universe at US$370 billion. While the fund of funds space has grown both in size and number over the past year, the pace of growth (6% by number and 55% by assets) has slackened relative to the frenetic levels seen in 2003 (23% by number and 129% by assets) and 2004 (17% by number and 173% by assets). Figure 1 below gives a more comprehensive picture of the industry growth over the years.
Figure 1: Growth in Number and Size of Funds of Funds Over the Years
This write-up aims to review some of the underlying key trends in the size, structure and performance of the fund of funds universe, to help better understand this growth. The data used in the analyses of the various trends, are based on the size, structure and related details of a sample of 1,855 funds of funds, and the performance and asset growth details of 804 funds of funds.
Current Industry Structure
I. Strategy Employed
Funds of funds, by definition, seek diversification of their asset allocations with respect to geographic mandate or investment style or both. It comes as no surprise then, that the majority of the funds of funds in the Eurekahedge database are multi-strategy funds and/or funds with a global investment mandate. As can be seen from the figures below, 74% of the industry's assets are in multi-strategy funds of funds (Figure 2) and close to 70% of the same assets are invested globally (Figure 3).
The equity long/short strategy, with a 12% share of total assets, is the next most popular among funds of funds. That said, funds of funds allocating to hedge funds employing other strategies such as macro are gradually gaining ground and the asset flows pertaining to this trend are discussed elsewhere in this write-up.
Figure 2: Breakdown of Fund of Funds Assets by Strategy
II. Geographic Investment Mandate
On an analysis of the composition of fund of funds assets by investment region, it is apparent that, aside from those with a global mandate, these funds are mainly parked in North American vehicles (26%), and only marginally in Europe and the Emerging Markets (6%). But these assets do find their way into higher return generating markets, given that nearly 50% of the assets in North American hedge funds have a geographic mandate outside North America.
Figure 3: Breakdown of Fund of Funds Assets by Investment Region
III. Location of Management Company
Table 1 shows that the United States, the United Kingdom and Switzerland are the most popular locations for funds of funds to set up offices in. Between them, they account for nearly three-fourths of all funds of funds. This is hardly surprising, considering that the traditional key players in the global fund of funds space have been private banks and pension funds from these regions. As a case in point, nearly 90% of the assets in Asian hedge funds come from these three locations, although not necessarily entirely from funds of funds.
A look at the average size of fund of funds assets, however, tells a slightly different story. Hong Kong, owing to its sophisticated financial markets vis-à-vis other markets in the region, has been rising as a key Asian location, especially for funds that are keen on a more "ear to the ground" approach to investments in the region. So, while its footprint in terms of number of funds is still rather small, the average size of assets located in Hong Kong (US$148 million) is the largest among all locations – an indication of the robust returns in the region.
| HQ Location | % Share by Number | % Share by Assets | Avg Asset Size (US$m) |
|---|---|---|---|
| Hong Kong | 1% | 2% | 148 |
| France | 5% | 8% | 133 |
| Luxembourg | 1% | 1% | 123 |
| United States | 34% | 46% | 121 |
| Channel Islands | 2% | 2% | 107 |
| Switzerland | 14% | 12% | 77 |
| United Kingdom | 23% | 19% | 74 |
| Cayman Islands | 2% | 2% | 71 |
| Ireland | 1% | 1% | 67 |
| Bahamas | 1% | 1% | 56 |
| Canada | 1% | 1% | 51 |
| Netherlands | 2% | 1% | 42 |
| Bermuda | 7% | 3% | 30 |
| Others | 6% | 2% | 30 |
Growth in Assets
Seen purely in terms of growth rates, it would appear that the pace of growth in the size of funds of funds this year has slackened in comparison with that of the last couple of years. The industry registered robust year-on-year asset growth of 173% in 2004, against the relatively modest 55% in 2005. However, this is a case of starting from a lower base, and the quantum of asset growth was not significantly lower than that seen in 2004. Fund of funds assets grew by an estimated US$131 billion in 2005 and by about US$151 billion in 2004.
Now, for a review of how this growth was distributed among the various strategies and investment regions: Table 2 depicts the year-on-year growth in assets in some of the fund of funds strategies. In a year that saw uniformly lower growth rates as compared to 2004, macro funds notably registered above-average growth, rising 96% over assets parked in these funds in the previous year.
| Year | 2005 | 2004 | 2003 |
|---|---|---|---|
| Arbitrage | 7% | 13% | 8% |
| Equity Long/Short | 51% | 208% | 90% |
| Macro | 96% | 156% | 23% |
| Multi-Strategy | 71% | 158% | 231% |
| Others | 28% | 39% | 29% |
As more funds of funds direct their assets towards the emerging markets, as evidenced by the comparative year-on-year asset growth rates for Asia Pacific in Table 3, they are bound to gain in depth and we might see an increase in funds focusing on other strategies such as macro, relative value and event-driven funds of funds. For instance, in terms of average asset size, event-driven funds of funds are already the largest in our sample (US$143 million). In comparison, multi-strategy funds have an average size of US$94 million, and long/short funds US$63 million.
| Year | 2005 | 2004 | 2003 |
|---|---|---|---|
| Asia Pacific | 729% | 284% | 371% |
| Europe | 31% | 21% | 37% |
| Global | 56% | 108% | 161% |
| North America | 31% | 210% | 200% |
Performance Review
I. Performance by Strategy
Funds of funds had a moderately good run in 2005, with the benchmark Eurekahedge Fund of Funds Index1 rising 7.6% for the year. Barring the low volatility of the initial few months and the end-of-the-year profit-taking in October, markets have been, in the main, positive. Among the strategy indices, equity long/short (+10.64%) and distressed debt (+8.72%) funds of funds were the top performers on the basis of YTD returns, benefiting from robust equity markets and tightening credit spreads respectively.
But on a ranking by risk-adjusted returns in order to compare returns over a longer term, as shown in Table 4, arbitrage funds of funds turn up tops with an annualised return of 6.7% and a volatility of just 2.2%. Distressed debt funds are the next best return-generators with an annualised return of 9.4% and a volatility of 5.3%. This is owing to the concentrated and isolated evaluative model followed by these strategies.
| Investment Strategy | % Share (No.) | 2005 YTD2 Return | 2004 Return | Annnualised Return | Sharpe Ratio | Rank |
|---|---|---|---|---|---|---|
| Arbitrage | 3.0% | 3.72 | 3.65 | 6.67 | 2.63 | 1 |
| Others | 0.4% | 8.54 | 7.93 | 9.7 | 1.73 | 2 |
| Distressed Debt | 1.3% | 8.72 | 12.08 | 9.41 | 1.61 | 3 |
| Multi-Strategy | 68.0% | 7.25 | 8.36 | 7.81 | 1.51 | 4 |
| CTA | 2.0% | 1.35 | -1.2 | 9.99 | 1.43 | 5 |
| Macro | 1.4% | 4.04 | 2.73 | 7.45 | 1.4 | 6 |
| Event Driven | 0.9% | 5.3 | 8.79 | 7.6 | 1.39 | 7 |
| Equity Long/Short | 19.0% | 10.64 | 7.62 | 6.7 | 1.11 | 8 |
| Fixed Income | 2.0% | 4.69 | 7.79 | 5.48 | 0.98 | 9 |
| Relative Value | 2.0% | 5.91 | 6.31 | 5.16 | 0.85 | 10 |
Figure 4 tries to uncover "dark horse" strategies that are expected to do well in the near term, by pitting the average size in each of the strategies against the respective Sharpe ratio. It is evident that arbitrage, CTA and macro funds are low on asset size but high on risk-adjusted returns, suggesting that there could be a lot of potential in these strategies. This would of course be subject to the allocators' perception of investment avenues and constraints.
Figure 4: Average Assets vs Risk-adjusted Returns by Strategy
II. Performance by Investment Region
Among the five broad investment regions, Emerging Markets are of particular note, as they have recorded not only the highest returns for 2005 YTD (a stellar 22.6%), but also the highest annualised returns (9.5%) over the years. They are also among the top-performing regions on the basis of risk-adjusted returns (Table 5). This is hardly surprising, considering the heightened interest in the emerging markets of Asia, Latin American and Eastern Europe, in recent years.
| Investment Region | % Share (No.) | '05 YTD Retn | '04 Retn | Ann. Retn. | Sharpe Ratio | Rank |
|---|---|---|---|---|---|---|
| North America | 13% | 5.89 | 7.62 | 7.56 | 0.95 | 1 |
| Emerging Markets | 2% | 22.56 | 14.54 | 9.47 | 0.89 | 2 |
| Global | 72% | 6.67 | 7.6 | 7.58 | 0.88 | 3 |
| Europe | 6% | 11.52 | 8.35 | 7.65 | 0.79 | 4 |
| Asia Pacific | 6% | 13.58 | 8.24 | 4.24 | 0.46 | 5 |
And as is apparent from Figure 5, the emerging markets also seem to be slated for further growth in the near term, as more funds chasing these high risk-adjusted returns, flow into the region.
Figure 5: Average Assets vs Risk-adjusted Returns by Investment Region
III. Index Performance
Three clear trends may be noticed from the following index comparison chart – 1) both the Eurekahedge fund of funds and hedge fund indices have outperformed the MSCI equity index; 2) fund of funds and hedge fund indices have similar trend lines and the former trail the latter; and 3) multi-strategy indices have more or less consistently outperformed long/short indices, particularly so in the case of fund of funds indices.
While none of these trends are really surprising, what is impressive is the margin by which hedge funds and funds of funds have outperformed the benchmark equity index, reaffirming the ability of these funds to generate absolute returns irrespective of market conditions.
Figure 6: Index Comparison Chart
Outlook for 2006
Going into 2006, the investment environment looks very positive for funds of funds. This is not merely owing to the momentum of the second half of 2005.
Investment region wise, while Asia Pacific is still enjoying significant asset inflows (refer to Table 3); funds of funds are increasingly broadening their emerging markets exposure beyond Asia. Although both the indices turned in robust returns, the Eurekahedge Asia-Pacific Fund of Funds Index was consistently outperformed by the emerging markets index over the past couple of years. The former returned 8.2% and 14% respectively, to the latter's 14.9% and 20.2%. We expect 2006 to witness a surge in asset inflows into other emerging markets such as Latin America and Eastern Europe. Despite three years of gains, valuations continue to be reasonable because profit growth has overtaken share price growth.
On the strategies front, prospects for arbitrage funds of funds look promising. Assets in arbitrage funds, particularly convertible arbitrage, have shrunk considerably after healthy returns in the past (as implied by the annualised return of 6.7% and the 2005 return of just 3.7% – refer to Table 4). Furthermore, a buoyant world economy and strong corporate profitability and M&A activity, should support, if not boost, global equities in the near term, spelling good news for equity long/short and special situations funds of funds.
On the whole, 2006 presents a benign growth picture. Having said that, it would be prudent to examine some of the potential negative surprises such as decelerating profit growth, rise in inflation, reduced consumer spending or a collapse in property prices in the US or Asia. Any of these would cause a decline in global trade, adversely affecting fund of funds performance.
Footnote
1 With 803 constituent funds.
2 Year-to-date returns until November 2005.
