The Road Ahead for Hedge Funds: Pot holes or sink holes?

As Dow Jones points out today, hedge funds were “hard hit by the downturn on equity markets for the first half of 2008”. They cite new Morningstar data showing that US-based equity hedge funds are down over 2% for the year.  Hard hit?  Yes.  But not compared to long-only funds – down nearly 12% YTD.

In fact, Morningstar’s own press release yesterday observed:

“Overall, hedge funds, including funds of hedge funds, buffered the traditional stock and bond markets over the second quarter. Equity and bond markets saw losses all over the world, while the Morningstar Fund of Hedge Funds Index gained 1.43%.”

The Morningstar release goes on reveal that performance chasing is alive and well in Hedgistan.  While we have reported extensively about the flow of assets from smaller hedge funds to larger hedge funds, Morningstar’s data shows that money is also flowing quickly from stinky funds to ones that have maintained their bouquet through the credit crunch:

“Morningstar’s hedge fund flow data also show that, through May, assets moved to the Morningstar-rated 4-, and 5-star hedge funds, and redeemed the 1-, 2-, and 3-star hedge funds. Four- and 5-star hedge funds received more than $10 billion in new assets through May, while 1- and 2-star hedge funds bled almost $10 billion in assets over the same period.”

It’s against this rather depressing backdrop that the McKinsey Global Institute released its annual report yesterday on “The New Power Brokers” (that’s SWFs, hedge funds and PE funds, in case you’re not one of them).  The subtitle of the report “…Gaining Clout in Turbulent Times” seems to suggest that hedge funds may have simply hit a bump on the road.

Here’s a side-view of that pot hole…

The chart on the right is more important than most hedge fund asset figures you hear quoted each month because it shows asset flows (ignoring the effect of positive or negative returns).  Thus, it captures investor appetite for hedge funds.  While appetite and returns are obviously correlated in the long run, they can run counter to one another in the short term.  For example, Q1 returns were negative, but new asset inflows shored up the loss and led to a slight increase in AUM.

Still, as Morningstar says, hedge funds have been performing relatively well compared to long-only funds.  In McKinsey’s own words: “Nearly every hedge fund strategy beat the S&P500 between March 2007 and March 2008”.

Who knows if Q2’s relatively strong results for hedge funds will bring in new assets or whether the pot hole will turn into a sink hole.  But it does suggest that hedge funds may offer the best detour around the obstructions ahead.

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  1. Fouad
    July 18, 2008 at 7:55 am

    How can one compare the performance of hedge funds with long only equity funds? One of the selling points of hedge funds is that they are uncorrelated with the equity market, and therefore the comparison is out of place!

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