IMF taps hedge barometer
Hedge funds recorded on average modest returns on capital under management during 2000, outperforming most major market indexes. The number of hedge funds and, to a lesser extent, total capital under management has rebounded from the contraction of late 1998 and 1999. The limited available information suggests that the main sources of inflow to hedge funds were pension funds, insurance companies and major banks.
Investment allocations by these investors still appear to represent a small percentage of portfolio assets. Average hedge fund size looks like it has decreased, mainly due to the closure of several large funds in 2000. These closures reflected two considerations: a reassessment of the risk-adjusted expected returns on large, directional positions on asset prices; and the perception that increased scrutiny of hedge fund investments would adversely affect potential returns. As expected, the discipline of hedge funds appears to have increased since the near-collapse of LTCM. However, whereas disclosure to counterparties has improved, other aspects of disclosure (even to investors) remains limited.
Against the background of poorly performing securities, hedge funds recorded modest positive returns overall during 2000. The CSFB/ Tremont hedge fund index – probably the most widely-used barometer – rose 5% last year. In comparison, the Dow Jones index fell 5%, the S&P500 index lost nearly twice that and the Nasdaq index dropped nearly 40%. Even though hedge funds outperformed many stock and bond indexes, the Sharpe ratio for the CSFB/ Tremont index was negative, implying that, on average, hedge funds returned less than the risk-free rate (the yield on US T-bills) despite being significantly riskier.
Performance varied significantly with investment style. Most investment styles outperformed the major market indexes, although one third of funds by investment style fund classes had historically low or negative Sharpe ratios. Emerging market funds, the best-performing in 1999, were unambiguously the worst in 2000 while convertible arbitrage funds and those specialising in short selling were the best performers.
Following the 1998 turmoil in global financial markets, three trends have emerged: a rebound in industry size, a decline in the role of the large macro funds; and improved market discipline. As a side effect, liquidity in a range of markets has decreased- including developed and emerging debt and FX markets. Activities in OTC derivatives and some underlying markets have become highly concentrated, and these markets are perceived as less liquid than they were in the mid to late 1990s.
In retrospect, the 1998 turmoil was responsible for the closure of many large and small hedge funds as well as the winding up of LTCM. Many consider this consolidation a cleansing process for the industry as it involved the closure of poorly-performing funds. More generally, hedge fund investment strategies were reoriented away from riskier types of arbitrage strategies and directional bets on specific asset prices to more classic market-neutral strategies.
Because hedge funds still do not face public reporting requirements, it is difficult to measure growth in the industry since 1998. Most hedge fund data vendors – the main source of estimates of industry size a few years ago – no longer report estimates of industry size. Media reports (the basis of which are, incidentally, unknown) suggest the size of the hedge fund industry has rebounded since 1999, especially in terms of the number of hedge funds.
Total capital under management has grown more slowly than the number of hedge funds, apparently reflecting the closure of several large funds. Some of the capital that had been invested in macro schemes has been reinvested in other strategies, especially market-neutral funds. However, limited information on the industry also makes it difficult to tie down the magnitude and sources of inflows since 1998.
The available evidence indicates that pension funds and insurance companies as well as private banking arms of major banks have been important sources of demand for hedge fund investments. A recent Financial Times survey of European fund managers found that more than a third invest in hedge funds, more than double the number a year ago. Hedge funds are increasingly viewed by institutional asset managers as a distinct asset class that provides potentially significant diversification. For example CalPers, the California-based pension fund, established a $1bn hedge fund programme last December.
Much of the concern in 1998 about hedge funds was related to the extent of their leverage. However, available data suggests that leverage has probably fallen. The weighted-average leverage ratio for all hedge funds that report to MAR/hedge fell from 232% in late 1999 to 168% in late 2000. Virtually all styles of hedge funds had lower leverage in 2000 than the previous year.
Another possible barometer of leverage is the amount of bank lending to offshore centres where many hedge funds are domiciled. Bank lending to the non-bank sector based in offshore centres has risen about 10% per annum since the end of 1998. This is a slightly lower growth rate than that of capital under management in the hedge fund industry using MAR/hedge figures.
The above is an extract from the IMF report “Recent developments in the hedge fund industry”