Hedge funds rally, but not as much as the market.
The Morningstar MSCI Composite Hedge Fund Index, an asset-weighted composite of nearly 1,000 hedge funds in the Morningstar database, increased 1.9% in January but fell short of the MSCI World NR Stock Index's 5.0% rise. This marks the hedge fund index's largest monthly gain since December 2010. Overall, most hedge fund strategies provided positive returns in January but trailed the large gains seen across equity markets. Long/short equity strategies were best positioned to participate in these rallies and delivered the month's highest increases.
The Morningstar MSCI Security Selection Hedge Fund Index, which includes long/short equity funds investing across all geographic regions, rose 3.6% in January. Better-than-expected macroeconomic data from the United States and China, as well as improved liquidity in the European banking system, fueled an equity market rebound globally.
Long/short equity strategies focusing on emerging markets posted the largest monthly gains. The Morningstar MSCI Emerging Markets Hedge Fund Index rose 4.4% but still lagged the MSCI Emerging Market Stock Index's 11.3% climb. Improving investor confidence, as well as strong manufacturing and employment data from Germany, helped European markets shrug off lingering sovereign debt issues. The Morningstar MSCI Europe Hedge Fund Index and MSCI Europe Stock Index increased 3.0% and 4.7%, respectively.
In the United States, strategies focused on smaller-capitalization stocks outperformed as risky assets benefited the most from improving market sentiment. The Morningstar MSCI Small Cap and North America Hedge Fund Indexes increased 4.4% and 2.7%, respectively. The Russell 2000 and S&P 500 stock indexes, by comparison, jumped 7.1% and 4.5%, respectively. This represents the S&P 500 Index's strongest January performance in more than a decade.
Bond prices also rose in January on news that the Federal Reserve would extend its near-zero interest-rate policy until the end of 2014. The Morningstar MSCI Specialist Credit Hedge Fund Index, which includes funds that lend to credit-sensitive issuers, increased 2.5% against the BarCap Global High Yield Index's 3.7% climb. The Morningstar MSCI Fixed Income and Morningstar MSCI Long-Short Credit Hedge Fund Indexes also posted gains, increasing 1.9% and 1.8%, respectively.
Only two hedge fund indexes tracked by Morningstar declined in January. The Morningstar MSCI Currencies Hedge Fund Index slipped 0.1% for the month, as some trading strategies struggled with the intra-month reversal of the euro. Short sellers also failed to deliver in the bullish equity-market environment and the Morningstar MSCI Short Bias Hedge Fund Index tumbled 6.2%.
Hedge funds in Morningstar's database leaked $2.7 billion in December, the largest outflows seen since July 2009. Hedge funds overall experienced a turbulent fourth quarter--investors pulled $2.3 billion from funds in the database in October but then poured $1.2 billion back in during November. During 2011 overall, investors added $17.2 billion to hedge funds in Morningstar's database. The bulk of those assets went to systematic futures funds, which netted $15.3 billion throughout the year.
Event-driven hedge funds received the most redemptions in December, with the category experiencing outflows of $1.1 billion. This marks the sixth straight month of outflows for the strategy. Funds in the U.S. long/short equity and convertible arbitrage categories also experienced sizable outflows, losing $668 million and $240 million, respectively. Only five of the 21 hedge fund categories enjoyed inflows in December--the largest of which was the long/short debt category, which netted $364 million.
Funds of funds in Morningstar's database also suffered from massive redemptions, leaking $3.1 billion in December. This marks the largest monthly outflow seen in nearly three years, since April 2009. Investors pulled out $8.1 billion overall from funds of funds during 2011.