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October Hedge Fund Review

The markets’ rebound catches hedge fund managers off guard.

Josh Charney, 02/28/2012

In October, the Morningstar MSCI Composite Hedge Fund Index, an asset-weighted composite of nearly 1,000 hedge funds in the Morningstar database, rose 1.1%, a significantly lower rise than the MSCI World NR Stock Index's surge of 10.3%. Though most strategies posted positive figures in October, hedge funds overall failed to fully participate in the equity market’s massive rebound in October. The abruptness of the market’s reversal, coupled with lingering bearish sentiment, likely caught some defensively positioned managers off guard.

U.S. and European equity markets surged in October after the eurozone's decision to allow Greece to write down its debt. Stock-picking hedge fund strategies significantly lagged the equity markets, as the Morningstar MSCI North America and the Morningstar MSCI Europe Hedge Fund Indexes rose only 5.0% and 3.4%, respectively. Emerging-markets hedge fund strategies, represented by the Morningstar MSCI Emerging Markets Hedge Fund Index, increased only 4.1% in October, even though emerging-markets stocks outpaced those of developed markets. Similarly, the Morningstar MSCI Small Cap Hedge Fund Index rose only 6.8% relative to the Russell 2000 TR stock index's 15.1% jump.

Arbitrage strategies, which seek to hedge most stock market risk, posted modest but positive returns in October. The Morningstar MSCI Relative Value Hedge Fund Index rose 1.0% and the Morningstar MSCI Merger Arbitrage Hedge Fund Index increased 1.5%, the best monthly returns so far this year for these categories. Merger activity increased and deal spreads compressed in October, contributing to the positive performance.

Credit strategies failed to deliver last month as thawing sovereign debt fears in the Euro-zone dampened bond performance. The Morningstar MSCI Specialist Credit Hedge Fund Index fell flat in October, while the Morningstar MSCI Long-Short Credit Hedge Fund Index declined 0.8%. Fixed income arbitrage funds performed slightly better. The Morningstar MSCI Fixed Income Arbitrage Hedge Fund Index eked out a 0.8% rise. Distressed strategies, which invest in riskier equity and debt securities across the capital structure of struggling corporations, rose more than other credit strategies. The Morningstar MSCI Distressed Securities Hedge Fund Index increased 1.8% in October, after falling 3.5% and 4.2% in the previous two months, respectively.

Momentum-driven hedge fund strategies experienced losses for the third-straight month. The Morningstar MSCI Systematic Trading Hedge Fund Index, which includes hedge funds trading futures contracts according to price trends across asset classes, dropped 3.0% in October, more than all other Morningstar hedge fund categories. Price reversals in contracts such as Japanese government bonds, the U.S. dollar/ Japanese yen exchange rate, and industrial metals contributed to declines.

While some categories, such as systematic futures, global long-short equity and debt, and diversified arbitrage, saw modest inflows in September, single-manager hedge funds in Morningstar's database overall experienced net outflows of $165 million. The U.S. long-short equity category leaked more than any other category during September ($328 million) and has lost $1.8 billion through Sept. 30, 2011. European long-short equity and global macro funds also struggled, with both categories losing roughly $200 million. Despite outflows in September, single-manager hedge funds in Morningstar's database collectively attracted inflows of $19.1 billion over the past nine months and $20.2 billion over the past 12 months through September. In contrast, hedge funds of funds in Morningstar's database have continued to lose assets, as the group overall saw net outflows of $589 million in September and $2.5 billion over the past 12 months.

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Josh Charney is an alternative investments analyst at Morningstar.
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