Corporate Financing Analysis - Hedge Fund Bull Run Continuing To Find Momentum - 09 OCT 2017


In terms of returns, equities might be hard to compete with, but the performance of the global hedge fund industry is continuing on a positive trajectory that will continue to keep investors on side for now. According to data from research house Preqin, hedge funds posted gains of 0.97% during the month of August, extending their bull run for returns to ten consecutive months. August's positive performance followed on from returns of 0.57% and 1.13% most recently in June and July, respectively. So, correct to the data published for the first eight months of 2017, the benchmark Preqin All-Strategies Hedge Fund benchmark has now returned 7.03% in the year-to-date period, and 9.79% over the past 12-months.

US Hedge Funds Health

Comparatively, the benchmark S&P 500 equity index in the US is up by 12.53% since the beginning of 2017, and is some 18.60% above where is stood a year previously - data from Bloomberg correct to October 2 shows. All of this data falls in line with our view back at the start of 2017 that even though hedge fund returns will fail to compete with those found in equity capital markets ( see 'Hedge Fund Returns To Continue Being Outpace d By Equities', January 25 2017), alternative investors will keep faith with the 'hedges' for the time being.

Although we note that we also cautioned back in Q117 that funds will have to work hard to keep their investor base happy over the medium-to-long term, with a focus on fees likely to be central to any sustained bull run in investor backing of the asset class ( see 'Hedge Fund Fees: Adapt Or Die', March 22 2017). Meanwhile for the time being, our core view for the global hedge fund industry remains bullish in the near term.

Positive Returns
Single-Manager Global Hedge Fund Strategy Performance, By % Return
Source: Preqin , BMI

August Positive Across The Board

A breakdown of recent hedge fund performance shows that all leading strategies produced positive returns during August, with both equity and macro strategies funds both generating an above average monthly performance of 1.07%, the highest returns of all leading hedge fund strategies. This represents a drop of from 1.51% return for equity strategies but an increase from a 0.55% return from macro strategies a month earlier in July 2017, however.

At the opposite end of the spectrum was the global hedge fund strategy which provided the lowest return during the month of August, relative value, which returned 0.37%, down from 0.63% a month earlier. Commodity Trading Advisors (CTAs) meanwhile continued their recent positive run during August, posting a performance return of 1.27% for the month. In terms of the geographical breakdown, emerging markets hedge funds continued their outperformance posting a 2.47% return during August (well ahead of the 1.05% found in developed markets), which boosted the region's y-t-d return to 12.26% and 13.61% since the same stage in 2017, to post a 2.47% return during August.

Two Strengthening Headwinds

Despite the late summer positivity in the global hedge fund industry, BMI notes that there is still plenty of reason for fund managers and investors to be looking over their shoulders and our view remains that the current market rally will be unsustainable over the medium term. In short, what goes up must come down. To support this view, we point to two strengthening headwinds in the global hedge fund space : slowing fund inflows, and the ongoing focus on fees.

Inflows Slowing

Global hedge fund inflows enjoyed a banner quarter in Q117, and while second-quarter data shows that capital is still flowing into the asset class we highlight that the pace at which it is doing so has slowed dramatically - something which backs up our prediction that the current bull run for hedge funds cannot continue too much longer ( see 'Hedge Funds Troubled Despite Positive Returns', May 17 2017).

According to Preqin data, hedge funds recorded positive net asset inflows totaling USD5.0bn during the three-month window ending September 30, bringing total H117 asset flows to USD24.7bn. While this may seem positive, we highlight that this marks a distinct contrast with Q117 inflows, which tallied as much as USD19.7bn. Furthermore, capital flows were not even across the industry: while CTAs saw the greatest net inflows of USD10.4bn during the second quarter, equity strategies funds recorded their sixth consecutive quarter of outflows, totaling USD12.4bn - a disparity in fortunes which we believe does not bode well for the future outlook for the asset class over the coming quarters ( see 'Net Inflows Drop Bad News For Hedge Funds', August 30 2017).

Fees Remain An Issue

Hedge funds fees have long been a point of conflict between fund managers and investors. The traditional fee format for the hedge fund industry (as well as the private equity arena) has been the so-called '2 and 20' structure. This refers to the 2% fee levied on assets in management fees, regardless of performance, plus 20% of fund profits. Unsurprisingly, such high fees have proven to be hugely unpopular with investors - a problem that has become even more acute owing to the hedge fund industry's disappointing returns in the aftermath of the global financial crisis. With investors becoming increasingly outspoken against such fees, fund managers have been forced to sit up and take note.

A change in structure is occurring but not quickly enough: the 'Q2 2017 HFR Market Microstructure Report' published by Hedge Fund Research (HFR) reported that the average management fee fell by 0.1% to 1.46% and incentive fees declined 0.10% to 17.2% during the three months through to June 30. Meanwhile, the average management fee for funds launched in Q217 fell to 1.28%, as compared to 1.4% for Q117 launches, while the average incentive fee for funds launched in the second quarter declined to 16.9%, down 21 basis points from the prior quarter.

HFR also estimates that around 30% of all currently active hedge funds continue to charge management and incentive fees equal to or greater than the previous benchmark of 2-and-20. Looking ahead, we caution that plenty more work will need to be done, and that the average charge by the 'hedgies' will need to drop further still, to keep investors on board for the medium-to-long term.