The number of new European-based hedge funds grew rapidly over the past year, though growth now appears to be slowing slightly. Investment bankers, analysts and fund managers continue to leave salaried jobs at major banks to set up boutique firms where the initial income stream may not arrive until two or three years after launch.

Funds launching today appear to be better structured (with focused risk controls and external directors) than they were four years ago. Whether this rapid growth constitutes a hedge fund "bubble" ready to burst or is just a fundamental/structural change in the asset management industry is the major question being raised by the media. The answer really depends on if there is a number of concurrent hedge fund blow-ups causing allocators (both leveraged and unleveraged funds of funds, institutions and family offices) to drastically reduce their hedge fund exposure across the strategy spectrum. Ultimately this will depend on performance and drawdown management. If hedge funds continue to outperform market indices (even with increasing fees) without suffering numerous meltdowns, the number of funds and the money allocated to them should continue to grow.

Strategy Breakdown

A plurality of European hedge funds by number (43%) are equity long/short, which compares similarly to the strategy breakdown of North American hedge funds but is significantly less than the 56% of Asian hedge funds that employ an equity long/short strategy.

Number of European Funds by Strategy

CTAs have been one of the best performing hedge fund strategies over the past three years, and the number of new CTA launches globally has risen. European-based managers employing CTA strategies now represent 12% of the entire European hedge fund universe, second only to equity long/short funds.

Macro and arbitrage strategies are tied for the third most popular European hedge fund strategies, with 8% market share by number. Fixed income and multi-strategy managers each represent 7% of the universe. It is surprising that relative value funds in Europe represent only 5% of the entire universe. In Asia relative value funds represent 6% of the total market by numbers. With the availability of short borrow in Europe easier than in Asia, one would expect a proportionally larger number of European relative value funds. Like in most hedge fund markets, event driven (4% of the universe) and distressed debt (2%) are the strategies with the smallest market share

.Europe is leading the way in the growth (based on number of funds and assets under management) of long/short credit funds when compared to the North American and Asian markets. This is primarily due to the depth of the credit default swap market and consequential skill sets of individuals who wish to launch these types of funds. The largest such fund is GLG Credit, but other names in this sector include Elgin, ORN, Regent Park and Cambridge Place.

Performance and Assets under Management

While European equity markets have fallen between 20% to 50% from their first quarter 2000 highs, European equity long/short hedge funds have held up reasonably well with annualised returns of 12%. However these returns were lower than the 17.7% average annualised returns seen in Asian and Japan equity long/short funds, although the risk free rate in US dollar-denominated Asia funds were substantially lower than European Central Bank rates throughout the last four years.

European distressed debt funds, like in Asia, were the best performers with annualised returns of 22.18%. Multi-strategy funds, which usually are heavily weighted to long volatility strategies, was the second best performing strategy with 13.87% annualised returns and annualised volatility of 9.39%. The average European CTA performance was similar to its global peers with 12.39% annualised returns.

Performance of European Hedge Funds by Strategy

Not surprisingly, most European hedge fund investors come from Europe. We believe that close to 75% of all money invested in European hedge funds originates in Europe and only 20% from the United States. With the continued strength of the Euro against the U.S. Dollar and Asian currencies loosely pegged to the Dollar, U.S. and Asian-based hedge fund investors could increase their allocation to Euro-denominated hedge funds in the coming years. The vast majority of European hedge funds have total assets under US$400 million.

Source of Funds for European Strategy Hedge Funds

Number of European Hedge Funds by Assets under Management (US$m)

Location Breakdown

Similarly to the unit trust industry, most European hedge fund managers are based in London. Approximately 54% of the market by number of funds is based in the United Kingdom, with a vast majority of these funds in London. France is second with 9% of the industry based in Paris. Surprisingly, more European hedge fund managers are based in the United States (8%) than in Switzerland (7%). The least number of managers are based in Germany (only 1%); though this is likely to increase as the ability to raise hedge fund money in Germany becomes easier with looser government regulations.

European Hedge Funds by Location

There is an interesting structural trend emerging in the business models of major fund houses in Europe whereby certain firms are building on their existing reputation and using it to launch multiple funds for investors. Some of these fund houses are purely hedge fund specialists such as Vega and GLG. Others like Gartmore, Henderson, New Star, Threadneedle and HSBC are hybrids that are leveraging their reputation in the long-only world and launching hedge fund products