Hedge funds sorely disappointed investors in 2011.
In December, the Morningstar MSCI Composite Hedge Fund Index, an asset-weighted composite of nearly 1,000 hedge funds in the Morningstar Hedge Fund database, rose 0.4% but ended the year down 2.7% , the second-worst annual performance since the index's inception in 1994. Hedge funds sorely disappointed investors in 2011. Macroeconomic headwinds, rising stock correlations, and choppy commodity markets all contributed to the lackluster performance of hedge funds last year, particularly those focused on stock-picking, international, and managed-futures strategies.
Stock-picking strategies across geographies struggled to deliver as correlations between individual stocks (as measured by the CBOE S&P 500 Implied Correlation Index) climbed in the second half of 2011. The Morningstar MSCI Security Selection Hedge Fund Index dropped 0.6% in December, ending the year in the red 8.3%, while the MSCI World NR Stock Index declined only 5.5%.
Amid the eurozone sovereign debt crisis and a general slowdown in emerging-markets economies, stock-picking hedge funds concentrating in European and emerging equities performed poorly on an absolute basis in 2011. The Morningstar MSCI Europe Hedge Fund Index managed to eke out a 0.2% gain in December but dropped 5.9% for the year, while the Morningstar MSCI Emerging Markets Hedge Fund Index declined 1.1% in December, down 11.8% for the year. On a relative basis, these numbers are more encouraging—the MSCI Europe and MSCI Emerging Markets passive stock indexes dove 11.1% and 18.4%, respectively. U.S.-equity hedge funds, on the other hand, managed to lose money in 2011, even as the S&P 500 Index rallied in the fourth quarter. The Morningstar MSCI North America Hedge Fund Index dropped 0.4% in December and finished the year with a 3.1% decline, while the S&P 500 rose 2.1%.
The absence of clear upward or downward price trends in many major futures markets in 2011 (crude oil, for example) as well as sudden price reversals in others (such as gold futures in September 2011) took its toll on systematic trading strategies, which bet on long-term momentum of futures contracts across different asset classes. Morningstar MSCI Systematic Trading Hedge Fund Index rose 0.3% in December but posted a 4.8% decline in 2011, its worst annual performance since its 1994 inception.
Arbitrage strategies were some of the few to deliver this year. The Morningstar MSCI Fixed Income Arbitrage Hedge Fund Index, which tracks funds that profit from pricing inefficiencies in both public and private debt, rose 1.5% in December, elevating its 2011 performance to 6.2%. Merger arbitrage strategies benefited from an increase in deal volumes, as companies with abundant cash and improving balance sheets sought M&A opportunities. The Morningstar MSCI Merger Arbitrage Hedge Fund Index rose 0.5% in December, pushing its annual return up to 4.2%.
In November, single strategy hedge funds overall saw outflows of 1.6 billion, and funds of hedge funds lost $235 million in assets. Global macro hedge funds experienced the heaviest redemptions of all categories, leaking $1.6 billion in assets. Debt arbitrage and U.S. long/short equity experienced modest inflows, bringing in $320 million and $204 million, respectively.