Corporate Financing Analysis - Emerging Hedge Funds To Continue Outperforming - 07 AUG 2017

Emerging hedge funds are going from strength to strength thanks to consistently strong returns, outpacing those in the broader global hedge fund industry. In BMI's view, the recent performance of emerging funds, and the desire among hedge fund investors to diversify their portfolios as the broader asset class struggles to compete with returns elsewhere - and especially those in the equity capital markets arena - we expect emerging hedge funds to see a rise in their share of global hedge funds assets under management (AuM) over the coming quarters. We caution, however, that the downside risk to this view is that such funds are fundamentally riskier for investors than more established funds, and if we were to see a sudden spike in risk aversion in the global investment community, then the current emerging hedge fund charge may see its rise begin to stutter. This, however, is not our core view.

Surprising To The Upside
% Performance Of Emerging Hedge Funds
Source: Preqin , BMI

Biggest Is Not Always Best

In the hedge fund industry, we note that small, first-time emerging market (EM) hedge funds - defined as either as those with AuM of USD300mn or less, which we define as 'small' for the purposes of this article; or those with a three-year track record or less, which we will define as 'new' for the purposes of this article - have been recording the strongest performance across the industry. Indeed, such funds have, in their first three years, consistently recorded returns which have outperformed the broader industry across the 12-month, three-year, and five-year timeframes. A breakdown of the two fund types shows that new funds have outperformed small funds across all of the three aforementioned timeframes. Preqin data shows that over the last 12 months, new funds have returned an average of 14.10% and small funds an average of 11.91%, versus a global industry return of 10.22%. Over the last three years, new funds have returned 8.52% and small funds 5.79%, compared with 5.31% globally; and lastly, over the past five years, new funds have returned 12.22% and small funds 8.98%, outpacing the 7.71% average return recorded across the industry at large.

Risky Business?

As mentioned above, there is, of course, a great deal of risk involved for investors who put their money into such deals. The risk for such EM funds stems from, first of all, the use of untested strategies with funds with little-to-no track of being tested through market cycles; and secondly, their vulnerability to potential capital market losses as a result of their small size. All the while volatility remains unthreatening, however, as a higher degree of risk comes with the opportunity for plenty of yield, as the average returns for emerging hedge funds have shown. For now, investors appear to remain comfortable with taking it on - especially when the level of risk involved is not always that great. Indeed, as Preqin data show, while new hedge funds do show slightly higher risk metrics, three-year volatility or both 'new' and 'small' funds have largely converged with that of the wider industry so far in 2017: volatility for small funds stands at 4.78% across the three-year timeframe, compared with 4.03% for new funds and 3.98% across the broader hedge fund industry. Meanwhile, over a five-year period, the average level of volatility is not too different either: for small funds the average is as high as 4.47%, while for new funds it comes out at 4.07%. Put in comparison to the broader industry as a whole, these averages are only marginally lower at a level of 3.70% , as shown by Preqin data. In sum, the disparity of returns between emerging funds and the broader hedge fund industry is a lot larger than the level of risk between the two, going a long way to explaining their recent rise in popularity.

The Underlying Headwinds

There are, of course, a range of further headwinds in the hedge fund industry at large which makes investing in emerging funds, and all hedge funds, risky; although these risks are more often than not elements which are likely to hit investments hardest away from developed markets. First and foremost for hedge funds, equities are proving impossible to compete with. Indeed, in a head-to-head between US hedge fund returns and US equity returns, there is only going to be one winner at present: equities ( see 'Hedge Funds To Continue Being Outpaced By Equities', January 25). This, however, is not the only risk at hand: we highlight that there are two further headwinds which have been hitting the hedge fund market in the form of net outflows from funds and the call to reduce fees (a topic which BMI has been tracking closely for some time now).

Stemming The Outflows

In the case of outflows, the problem has been stemmed for now but does continue to linger just under the surface. A difficult year for the industry in terms of net investor outflows across the board, both for funds based in emerging and developed markets, has since been followed by a turnaround in sentiment for the time being. Indeed, EM fund managers are currently well placed followed the recording of net investors inflows for five consecutive months since the start of the year (data for June 2017 is not yet available) - a new record for the asset class.

Continued Focus On Fees

In the case of hedge fund fees, this has become a real point of contention for the hedge fund industry and its investors over recent years ( see 'Hedge Funds Troubled Despite Positive Returns', May 17 2017). The call for hedge funds to reduce their fees and to diversify away from their traditional fee format has grown louder with each quarter which has passed. And hedge fund managers have sat up and taken notice: some fund managers in the US have started moving away from the traditional '2 and 20' model, (where hedge fund managers charge 2% of total asset value as a management fee, and 20% of any profits earned). While this has failed to trickle down to EM hedge funds as of yet, we believe that it will only be a matter of time before it does so. As Preqin data shows, the average fees declined across the duration of 2016, with the average management charge in the industry dropping to a level of 1.51% of assets among funds incepted in 2016, down from 1.57% charged during the two previous years.