The Eurekahedge European Hedge Funds database currently contains information on close to 2,2001 Europe-based hedge funds, an investment space currently valued at about US$350 billion. From humble beginnings at US$20 billion in the late 1990s, the industry has grown at a staggering annualised rate of 72% since end-2000. We estimate industry assets to reach US$390 billion in value by end-2006 – an increase of US$85 billion from the end-2005 figure. The following graph charts the growth of the industry over the past decade, together with forecasts for 2006.
This review seeks to provide a comprehensive overview of the current structure of the industry and some of the key trends that have shaped it over the past decade. In order to do so, we examine the broad trends in asset size and performance of the European hedge fund universe, further analysed and mined for key trends with respect to various aspects of this space (viz investment strategies, geographic focus, performance fees and redemption frequency). The data used in these analyses are based on the size, structure and related details of 1,804 unique hedge funds and the performance details of a sample of 881 funds.
Delving into a taxonomy of the broad industry growth trend seen in the earlier graph, this section takes a closer look at asset size dynamics among European hedge funds and performance patterns among funds of varying sizes. We first compared the current distribution of funds (a sample of 1,513 funds) by size against the distribution five years ago (355 funds), as shown in Figure 2 below.
Apart from the obvious trend seen in the graph (ie a greater concentration of funds towards the lower end of the asset size spectrum), there has also been a re-shuffling of the shares of different asset size buckets. Funds between US$20 and 200 million now account for nearly half of all funds (up from a 38% share earlier). This, coupled with the significant increase in the number of funds over the years, explains the quantum jump in average fund size from a mere US$27 million ten years ago to the current US$196 million.
Figure 2: Change in Number of Funds by Size over the Last Five Years
We then compared the initial and current assets under management (AuM), and performance over the last 12 months, of funds launched between the years 1995 and 2005. This is depicted in Figure 3 below, and as can be seen, older funds (in operation for more than five years) have performed far better than their more recent peers (whose returns averaged approximately 20%), and this is also reflected in the significantly higher volume of asset flows that these older funds have seen over the years.
Figure 3: Asset Growth since Inception and Average 12-month Performance by Year of Launch
But does fund size have any bearing on performance? Interestingly enough, we noticed just such a relationship in the more recent performance of the funds surveyed, when we compared the average returns of funds of varying sizes over the last 3 months, 12 months, 2 years and 5 years, depicted graphically in Figure 4. While the curve representing returns during the past five years does not offer much information (the data points were skewed by sub-normal returns in years 2002 and 2003), more recent data point towards a clear trend of diminishing marginal returns for funds with AuM of US$1 billion or above (note the inflection point for the ‘Last 2 years’ curve at the ‘US$501 - 1,000 million’ asset size bucket). In other words, there is an implicit cap on a fund’s size in order to ensure optimal returns, and every additional million that a US$1 billion fund increases its AuM by only pulls down its average returns.
Figure 5 further shows that not only do these funds experience diminishing returns beyond the ‘US$1 billion’ threshold, they also see a marked rise in volatility. It compares the average annualised returns (ie the annual yield of a fund implied by its returns since inception) and the associated risk (measured here as the average of the annualised volatility of all monthly returns of a fund since inception) for funds in each asset size bucket.
In this section we compare the dispersion of returns across two dimensions – a) mode of alternative investment, and b) period of investment. The rationale for the former was to see how European hedge funds have fared against their North American (developed) and Asian (emerging) peers on one hand, and funds of hedge funds and long-only absolute return funds on the other. The rationale for the latter was to examine performance and performance dynamics across different and changing market conditions. To facilitate an analysis of performance under different market conditions, we decided to compare the average returns (annualised) of the types of funds detailed above over the past nine years, in blocks of three years. Three years is a reasonable amount of time to factor in the influence of long-distance runners as well as sprinters (with a head-start afforded by benevolent market conditions) into the average performance numbers; while the past nine years offer an opportunity to study performance under both rising and falling markets. Figure 6, comparing benchmark indices in the global bond, equity and commodity markets makes this amply clear.
As may be noticed in later sections of this write-up, we have used the same comparative models detailed above in analysing performance trends of European hedge funds in terms of strategies, investment regions and performance fees charged.
Figure 6: Benchmark Index Performance Charts – May-97 to Apr-06
The following graph depicts the comparative dispersion of returns (of the middle 50% funds ie tracing returns between the 1st quartile and the 3rd quartile) over the past nine years, broken into three-year periods as described above. Several patterns emerge from this graph – a) European hedge funds have been consistently outperformed by their peers in other developed markets such as North America, as also those in emerging markets such as India; b) European hedge funds, however, have been the most consistent performers of the lot – with more stable returns than even those of funds of funds – as the dispersion of returns changed little across varying market conditions; c) hedge funds allocating to the developed markets proved far more resilient to tough markets than their emerging market peers (at least 75% of the funds in the former group generated positive returns during the period from May-2000 to April-2003, while the bottom halves of both long-only funds and Asian hedge funds have had a noticeably higher percentage of negative-returns-generating funds); d) Long-only absolute return funds, predictably, performed far better in rising markets; and e) Asian hedge funds tend to be long-biased owing to a relative dearth of shorting opportunities in the region, and are similar in their performance patterns to long-only funds.
Figure 7: Quartile Dispersion of Returns by Mode of Alternative Investment
In the coming sections, we examine the factors that have shaped the size and performance of the European hedge fund universe over the past decade or so. More specifically, these sections enquire which strategies and regions have seen or are seeing the most money flows, which ones have had the best performance and how are, if at all, performance fees and performance related, etc.
Starting the investigation into the strategy mix of European hedge funds, figures 8 and 9 chart the market-shares of strategies employed by a) assets under management, and b) number of funds, respectively. As is apparent, long/short equities is the dominant strategy on both counts but its share is gradually slipping away into more esoteric strategies. For instance, comparing the variance in the % shares in the two pies, one notices that in terms of average fund size, it is actually the event-driven funds that turn up tops, with 4% of the funds (1,800) managing over 10% of total assets (US$350 billion). Other funds that have a relatively high average fund size are arbitrage, macro and multi-strategy funds.
The following graph (Figure 10) further corroborates the afore-mentioned trend. It charts the changes in the strategy mix of European hedge fund assets over the last ten years. The equity long/short strategy, with a 40-50% share over the years, is depicted in the graph as an inverse function (ie making up the remainder of the 100% each year), so as not to drown out the rest of the data. From no allocation or a meagre allocation about ten years ago, arbitrage, event-driven, fixed income and macro funds have all grown to almost a one-tenth share each now. On the other hand, long/short equities and relative value funds significantly shrunk in size from a combined share of 80% in 1996 to slightly under 50% as on date. Arguably, these asset flows are chasing already-existing funds in these strategies (as indicated by the higher average fund size), hinting at improving efficiency in the utilisation of capacity over the years. Note that the distribution of total assets in the European universe is far more equitable now than it was ten years ago.
Figure 10: Change in Strategy-mix of Total AuM over the Years
Interestingly enough, this does not necessarily translate into the best returns for those strategies that enjoyed the most asset flows, as implied by Figure 11, which compares the performance (in terms of annualised and risk-adjusted returns) of the various strategies employed by European funds over the last nine years. This could be attributed to the leaner (and by extension more agile) structure of, and also the type of regional (emerging) markets pursued by the top performing strategies. Distressed debt, long/short equities and relative value funds, all bear evidence to this pattern of returns. As a matter of fact, distressed debt funds have not only seen the best returns across almost all three time periods compared, but have also significantly improved in the quality of those returns (Sharpe ratio of 4 for the period from May-2003 to April-2006). Arbitrage funds bore the anti-thesis of this pattern, steadily deteriorating in the quality of their returns. Long/short and event driven were no doubt helped along by benign markets as their respective Sharpe ratios registered a significant jump from periods 1997-2000 to 2003-2006. Also, the better performance of fixed income and CTA funds during the slump period of 2000 to 2003 should come as no surprise.
It was hinted in the previous section that the region invested in, and not merely the strategy employed, could play a part in the returns generated by the best performing funds/strategies. In this section, we test this hypothesis by seeking answers to such questions as: What is the breakdown of Europe-located funds by investment-region? How has it changed? Which regions are the assets chasing? Which regions have the best returns?
Figure 12 gives us a breakdown (by AuM) of the regions allocated to by Europe-located funds, and Figure 13 gives us the share (of total AuM) of each of the locations in Europe.
*Others include China, Eastern Europe & Russia, India, Korea, Latin America and Taiwan
*Others include Austria, Virgin Islands, Greece, Italy, Luxembourg, Netherlands, Spain and Turkey
As is evident, global and Europe-focused allocations currently soak up over 80% of the assets, while the emerging markets enjoy just over 10% of the allocations. On the locations front, UK is by far the most popular destination for fund managers setting up shop in Europe, arguably to do with the talent available in one of the world’s biggest financial capitals.
It is interesting to note that most of the allocations have a broad multi-country focus (“global”, “emerging markets”, “Asia ex-Japan” etc). This diversification of country risk would go some way in explaining the stability of European funds’ returns (as also a stronger correlation with fund of funds returns). But these precise features of the industry make-up seem set to change. Figure 14 looks at changes in the make-up of regional allocations in Europe-based assets, excluding those with global allocations (which account for the remainder of the 100% each year). It would appear at first glance of the figure that, unlike the case with strategy allocations, there has not been much change in terms of the breakdown of regional asset allocations. But the increases in European allocations occurred during a period of global market turbulence when a flight to safety and quality may be reasonably expected. Since then, allocations to the emerging markets have gradually diversified into focusing on single countries as well, as the appearance of Greater China, India and Korea allocations on the graph indicates.
Diversification into single-country markets is also justified by the returns that these regions are generating, as can be seen in the following comparison of quartile returns (annualised) by fund geographic mandate (Table 1). This table shows more clearly the addition of single-country allocations to the geographic mandate pie between 1997 and 2006 (refer to the perforated fields in the table). The quality of these funds’ returns (higher and tighter inter-quartile ranges) is also better than those of allocations to either the broader emerging markets or the developed markets. For instance, three of the top five regions (by the highest 1st quartile returns) between May-2003 and April-2006, are single-country allocations (highlighted in blue in Table 1). Furthermore, none of the funds investing in emerging markets (single or multi-country) during that period had negative returns to speak of.
Table 1: Quartile Performance by Fund Geographic Mandate
Having looked at some of the more obvious factors affecting a fund’s performance, we decided to direct our attention towards the performance fees charged by hedge funds and their impact on fund performance. We followed the same comparative models outlined in earlier sections of the write-up ie a comparison of returns and fees (in three-year periods over the last nine) among different modes of alternative investment, followed by a further inquiry into the strategic and geographic aspects of such fees and returns among European hedge funds. The aim was to isolate and depict the layer of returns skimmed off in the form of performance fees (the “icing on the cake”, if you will). To achieve this, we calculated the average annualised return and the average performance fee charged, for each of the three-year periods between 1997 and 2006, for each type of alternative investment fund, and lastly, (in the case of European hedge funds) for each strategy and investment region. Since the returns are calculated after netting off performance fees, we can work back to arrive at effectively the “manager’s share” of the total returns generated by a fund.
To illustrate, let us assume a fund with an NAV of 100 at the beginning of a year posts an annual return of 8% after charging a performance fee of 20%. This would mean that the fund actually posted a 10% return, one-fifth (or 20%) of which had gone to the manager as incentive/performance fee. We did the same with average fees and average annualised returns for each category outlined above2, and came up with Figure 15 below to begin with. In this graph, the brown area is the “icing” and the blue area, the “cake”. For instance, on average, Latin American hedge funds returned US$48 per annum for every US$100 invested at the beginning of the period from May-2000 to April-2003. Likewise, European hedge funds returned on average, US$14 per annum for every US$100 invested at the beginning the period from May-2003 to April-2006.
Figure 15: Changes in Average Performance Fees over Time by Mode of Alternative Investment
Almost all investment vehicles were characterised by spiking returns (and fees) during the period from 1997 to 2000, took a hit in the following period, and then rising to a more stable level in the last 36 months. Also, funds of funds and long-only funds have understandable thinner performance fee layers to their total returns. And among the hedge funds, emerging market funds (Latin American and Asian funds) have clearly had the best returns of the lot. Also, the average performance fee charged has gone down from a high of 21% during 1997 to 2000, to the current 19.5%. Most regional hedge funds have also gravitated down to this mean, with the exception of Asian hedge funds. In order to attract capital towards a fledgling destination for fund allocations, these funds charged a lower incentive fee of 18.5% on average. However, this figure is gradually catching up with the global average, as interest in Asia continues unabated (as illustrated by the changing make-up of Europe-based funds’ allocations) and is currently at 19.4%.
Turning the spotlight back on to the European funds, we next look at the strategies (Figure 16) and investment regions (Figure 17) that earned the lion’s share of performance fees. From the strategies graph, long/short, macro and relative value funds have seen a boost in average performance fees in recent years (from 18.6% during 1997-2000 to the current 19.6%), as demand for funds employing these directional strategies, particularly in the emerging markets, has increased, in a rising market environment.
Figure 16: Changes in Average Performance Fees over Time by Strategy
In terms of regions, funds investing in Europe and Asia, (especially the now-recovering Japan), have seen increased fund launch activity in the recent past and this resurgence in demand has translated into an increase in the performance fees charged (18.4% to 19.6%, on average, between 1997 and 2006) by these funds.
Figure 17: Changes in Average Performance Fees over Time by Fund Geographic Mandate
And lastly, we take a look at popular liquidity preferences among European hedge funds, from the standpoint of their mandated redemption frequencies, and their relationship to fund performance. Figure 18 shows the current distribution (by number of funds) of funds by redemption frequency period: the majority (70%) of European hedge funds have a 1-month redemption frequency period, while about 13% have a 3-month frequency clause and another 14%, a week or less.
Figure 18: Breakdown of Funds by Redemption Frequency
Logic would dictate that funds with a longer redemption frequency period have greater flexibility and control in terms of asset allocations and holding periods, and by extension, would enjoy better returns. This trend is not readily discernible at first glance of the average annualised returns during May-1997 to April-2000 (Figure 19 above). This can be explained by the fact that ten years ago, 99% of the funds had a frequency period that was either weekly (or less), monthly or quarterly, and among those three the relationship outlined above works ie funds with quarterly redemptions performed better than their monthly and weekly peers. As the European hedge fund universe broadened in scope, this has become a clearer and more obvious trend in recent years, with funds with longer redemption periods posting better returns during the period from May-2003 to April-2006.
To recapitulate, the European hedge fund universe has seen tremendous growth over the last ten years, growing four-fold by number of funds, and at over a 70% annualised rate by assets. And yet, their returns do not compare too favourably with those of most other alternative investment vehicles. The mismatch in asset flows and performance of European hedge fund strategies (strategies that saw the most asset flows were not necessarily the best performing) could go some way in explaining this conundrum. Also, the geographic mandate of these funds is highly diversified with marginal allocations (less than 15% of total assets) to the high-growth emerging markets.
That said, the general direction in which these funds are headed is encouraging. Allocations to the emerging markets are on the rise, the consistency and stability of returns hints at superior managerial talent, several of the directional and opportunistic strategies have registered 15-20% returns (annualised) in the past 36 months, and performance fee structures have become more flexible to accommodate a more diverse investor demand. And lastly, the corporate as well as economic outlook for Europe, particularly emerging Europe, in the short term, is bright. High confidence levels, robust cash flows and a conducive credit environment could very well translate into good opportunities in an already positive mergers and acquisitions climate. Directional and opportunistic strategies pursued with an emerging market focus, may be reasonably expected to perform well in the near future.
1 Funds surveyed include 885 European hedge funds, 2,446 non-European hedge funds, 1,157 funds of funds and 156 long-only funds.