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September Hedge Fund Review

A bad month, but with a few brightspots.  

Josh Charney, 02/28/2012

In September 2011, the Morningstar MSCI Composite Hedge Fund Index, an asset-weighted composite of nearly 1,000 hedge funds in the Morningstar hedge fund database, fell 2.3%, compared with a decline of 8.6% for the MSCI World NR Stock Index. Hedge funds lost 3.8% during the third quarter of 2011, but are up 0.8% over the last 12 months. Global stocks, on the other hand, (as measured by the MSCI World NR Stock Index) fell 16.6% during the third quarter and lost 4.3% over the past 12 months.

Hedge funds, by design, attempt to hedge out market risk. The Morningstar MSCI Composite AW hedge fund index has exhibited a three-year beta and correlation of 0.21 and 0.83, respectively (using monthly data through Sept. 30, 2011). Therefore, hedge funds acted exactly as expected in September. While they still followed the market downward during the economic turmoil, on average they didn't fall far. Some categories even posted positive results.

European and Asian equity-focused hedge funds in the Morningstar database were among the largest losers in September 2011, but these funds declined much less than their market benchmarks. The Morningstar MSCI Europe and the Morningstar MSCI Asia Pacific Hedge Fund Indexes fell 5.9% and 3.3 %, respectively, while the MSCI AC Asia and MSCI Europe Stock Indexes dove 7.9% and 11.0%, respectively. September marked the end of the worst quarterly performance for the Morningstar MSCI Europe Hedge Fund Index since its 1998 inception--an 8.5% drop. Similarly, the Morningstar MSCI Asia Pacific Hedge Fund Index slumped 8.4% in the third quarter, its worst quarterly performance in three years. Chinese equities tanked over slowing economic growth concerns, and Australian stocks pulled back as commodities plunged.

While there were few bright spots in September 2011, two hedge fund indexes managed to post positive numbers for the month. The Morningstar MSCI Short Bias Hedge Fund Index, which tracks bearish hedge funds, increased 10.4% because of its negative market exposure. The Morningstar MSCI Currency Hedge Fund Index eked out a 0.7% rise, as some funds in this index profited from a rising U.S. dollar.

The Morningstar MSCI Directional Trading Hedge Fund Index, which contains funds that take systematic directional bets on price trends in liquid derivatives, also benefited from a rising U.S. dollar. In addition, these funds took advantage of the rise in U.S. Treasury bonds fueled by the Federal Reserve's Operation Twist and investors' rush to safe-haven assets in September 2011.

Higher-risk equity markets performed relatively poorly in September. The Morningstar MSCI Emerging Markets Hedge Fund Index declined 6.8% on renewed fears of a global contraction and a sharp drop in commodity prices. Smaller companies, which tend to perform more poorly in downturns, also exhibited notably weak performance--the Morningstar MSCI Small Cap Hedge Fund Index fell 7.3% in September 2011 and 13.8% over the third quarter.

Event-driven strategies such as merger arbitrage and distressed securities also struggled in September 2011 amid falling equity valuations. The Morningstar MSCI Event-Driven Hedge Fund Index plummeted 5.1%, its largest monthly decline since September of 2008. Credit market spreads also widened during September 2011. The Morningstar MSCI Long-Short Credit Index fell 1.3% in September and 4.2% for the third quarter.

Although the third quarter was difficult for most hedge fund categories, investors continued to pour money in to hedge funds in Morningstar's database through August 2011. Total inflows during August for all single hedge fund strategies totaled $625 million, the sixth-straight month of inflows. Systematic futures hedge funds in the database netted the most inflows in August, $328 million in total, while Morningstar's global macro hedge fund category was hardest hit by outflows, totaling about $456 million. For the year to date through August, investors added almost $19 billion to single-manager hedge funds in the database, despite the fact that the average hedge fund, as measured by the Morningstar MSCI Composite Hedge Fund Index was down 3.9% year to date through September 2011.

Josh Charney is an alternative investments analyst at Morningstar.

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