A mere cyclical lowpoint

The relatively rocky ride that hedge funds have endured since the beginning of April this year has, quite rightly, caused much concern, but no real surprise, to participants. Tales of woe have become something of a mantra in some of the mainstream business media: the end is nigh for hedge fund returns; capacity flooding is suppressing returns; the standard of the manager community is falling; and so on.

So what effect has this duff patch of performance had on investment flows into hedge funds and indeed, are any of the reports of the death of hedge fund returns true?

Beginning in April of this year, the hedge fund market entered into a period of negative performance, or drawdown. While any non-performing period is of concern, when considered from a historic context and in relation to the risks and opportunities in the current market environment, we believe that hedge funds still present an attractive investment opportunity.

During the second quarter of this year, we saw total net inflows of $7.5bn (e6.11bn) into hedge funds, $4.5bn of which was into fund of funds, with the balance going directly into single strategy managers.

While this level of inflow is still very strong, it is a significant drop against the record inflows in Q1 of this year ($22bn) and a total inflow of $70bn during 2003.

One additional, and significant, factor that suppressed the net inflows during Q2 was the effect that the systematic trading redemptions from structured products had. A good estimate is that between $150bn and $200bn of hedge funds assets are in risk-based instruments that either provide leverage or principal protection (or both).

Having enjoyed the benefit of an increase in asset flows during the strong growth of 2003 and Q1 2004, these structures are now taking back part of that exposure. The effect is relatively modest at between 5 per cent and 10 per cent of the total exposure but this represents as much as $20bn that was redeemed during Q2. This would have been almost entirely from the fund of funds sector. It is therefore reasonable to assume that the actual gross inflows into fund of funds during Q2 were in fact nearer to $20bn and therefore consistent with the inflows seen in Q1.

Loss analysis

Through August the hedge fund industry approached a 2.0 per cent drawdown. To understand the significance of this, Hedge Fund Research analysed all the notable drawdown periods recorded since 1990 – a total of 11. In evaluating these periods, several measures were used, including the greatest ‘peak to valley’ loss (maximum drawdown), and the number of months from the initial loss to retrace past the previous high perform�ance point (recovery). (See table.)

Nothing unusual

Is there anything unusual about the current performance environment? No. While hedge funds have generated annual returns of 14 per cent with a standard deviation of 7 per cent since 1990 (as compared to the 10 per cent return and 15 per cent standard deviation for the S&P), they have had a number of periods of negative performance. These cyclical downturns are normal and, as they historically are followed by positive performance periods, represent buying opportunities.

How long will it last? On average, hedge fund industry drawdowns last seven months (median six months). The current drawdown is now into month six, and based on past returns, we believe that hedge funds should now start to generate positive returns and be into new highs by November/December.

Is it a good time to invest? Yes. For every drawdown period since 1990, the six months following the low month (max drawdown) have resulted in positive performance averaging 8.8 per cent return. Every 12-month period following the max drawdown point has been positive, generating an average return of 14.8 per cent. The probability is quite high that the max drawdown point has been reached. We believe an investment at this time has minimal downside and optimises the potential for generating double digit returns over the near term.

John Godden is managing director at Hedge Fund Research

Godden: good time to invest