Investors Are Getting Back into Hedge Funds

The data is in: Investors are getting back into hedge funds, at least those in Morningstar's database. After outflows of more than $55 billion in the first five months of the year, investors reinvested $1.4 billion in June (flow data lag returns by one month). Not terribly surprising, considering the market rally of the second quarter. Hedge fund investors may have been optimistic prior to June, but redemption requests (often quarterly) submitted in prior quarters and redemption gates instituted by fund managers could have had lingering effects.

Year to date, hedge funds are up 11.5% according to the Morningstar 1000 Hedge Fund Index (through Aug. 14). That's slightly better than the S&P 500, and a couple of percentage points worse than the MSCI World Index, and significantly better than bonds. We're seeing the most action coming from emerging-markets hedge funds, as we know those stock indexes are on a tear, and convertible arbitrage hedge funds, which saw many of their competitors wiped out in the blood bath of fall 2008. The Morningstar Convertible Arbitrage Hedge Fund Index is up almost 25% year to date through July, having mostly recovered from its 31.3% 13-month drawdown ending November 2008. Funds in the Morningstar Emerging Markets Hedge Fund Index, however, still show significant room for improvement. This index drew down 49.5% through February 2009, with more than 40 percentage points still left to recover. Year to date, this index is up 31.0%.

Along with convertible arbitrage and emerging-markets hedge funds, small-cap funds are profiting from the severe sell-off in 2008. Although the small-cap equity market is generally rife with pricing inefficiencies, last year's market dislocation offered even more opportunity in 2009. The Morningstar US Small Cap Equity Hedge Fund Index returned 4.5% in July, less than half the return of the Russell 2000 Index; but for the year through July 31, these hedge funds are up 21.4% while the benchmark has gained only 12.5%.

Morningstar Hedge Fund Index Performance

What hasn't worked this year? Exactly what worked last year. That is, managed futures trend-following. In 2008, the Morningstar Global Trend Hedge Fund Index proved to be the only hedge fund category index to post a significant gain, a whopping 9.9%. All other indexes posted large losses, especially the Morningstar Emerging Markets Hedge Fund Index. Trend-following hedge funds, those that take long and short positions in financial and commodity futures exhibiting upwards and downwards price trends, have been whipsawed by quickly changing trends in certain contracts, such as gold during July, and lack of trends in others, such as U.S. Treasury bonds in the first quarter of 2009. But investors should not abandon this strategy yet. In fact, the strategy is performing exactly as intended, as a diversifier. These funds remain uncorrelated to the traditional asset classes. Year to date the Morningstar Global Trend Hedge Fund Index is down 3.8%, while stocks and bonds are up. Trend-following and non-trend-following (but closely related) global macro funds received the bulk of investors' cash in June.

Funds of hedge funds are still experiencing outflows; according to Morningstar's database, more than $6 billion year to date through June. Interestingly enough, so are multistrategy hedge funds, which have lost almost $14 billion in 2009, more than any other hedge fund category, perhaps indicating that investors are more interested in allocating their own capital among various hedge fund strategies. It could also mean that investors prefer managers who stick to one strategy. The Morningstar Multi-Strategy Hedge Fund and Hedge Fund of Fund Indexes lost 21.7% and 22.3%, respectively, last year. Year to date through July, these funds are up 13.5% and 7.1%, respectively. Last year, both funds of funds outperformed the Morningstar 1000 Hedge Funds Index after fees, but this year, funds of funds have significantly lagged single-manager funds.

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