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Investing Specialists

Investors Are Getting Back into Hedge Funds

Better performance attracts $1.4 billion to hedge funds in June.

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%.