After the comparatively halcyon days for hedge fund investors in the 12 months ended June 30, storm clouds are brewing as chief investment officers and investment consultants calculate the impact on pension portfolios of negative third-quarter hedge fund returns.
For the year ended June 30, the HFRI Fund Weighted Composite index returned 11.5%. The first six months of 2011 didn’t greatly reward many hedge fund managers, but was at least benign with flat to moderately positive returns for most multistrategy and single-strategy managers. The HFRI Fund Weighted Composite index returned 0.76% year-to-date June 30.
But the summer’s extreme volatility and market uncertainty drove hedge fund indexes into sharply negative territory in the third quarter.
In fact, third-quarter returns were among the worst on record, according to Hedge Fund Research Inc. The HFRI Fund Weighted Composite index’s -5.5% return for the three months ended Sept. 30 was above the record low -9.6% in third quarter 2008, -9.2% in fourth quarter 2008, and -8.8% in third quarter 1998. Hedge Fund Research produces the HFRI index.
In most quarters, returns of hedge funds-of-funds indexes tend to lag returns of indexes that track multistrategy and single-strategy hedge funds by at least 100 basis points, but with a -4.73% return in the third quarter, the HFRI Fund of Funds Composite index outperformed multistrategy and single-strategy indexes.
“September was another challenging month for hedge funds, capping one of the worst performance quarters in history, driven largely by increased European sovereign debt risks. Stock markets are normally driven by fundamentals, with the key element being earnings per share and growth expectations. The market was driven down in the third quarter, not because stock fundamentals were poor, but because of the fear factor stemming from the European sovereign debt factor,” said Charles Gradante, co-founder of Hennessee Group LLC, New York.
“In response, managers have significantly reduced gross and net exposures in line with increased volatility,” Mr. Gradante said.
The Hennessee Hedge Fund index, returned -7.15% in the third quarter and -5.53% for the first nine months of 2011.
Despite the losses, hedge fund index returns outperformed both the S&P 500 and MSCI World index in the quarter. The S&P 500 returned -13.84% for the quarter ended Sept. 30, while the MSCI World returned -16.46%. The Barclays Capital Aggregate Bond index return was 3.82%.
Hedge fund returns also were negative in the nine months ended Sept. 30, but as in the third quarter, lost less than half as much as the S&P 500 return of -11.44% and the MSCI World’s return of -15.48% year-to-date Sept. 30. The BarCap Aggregate Bond index, by contrast, returned 8.99% year-to-date Sept. 30.
The Dow Jones Credit Suisse Core Hedge Fund index returned -6.8% in the third quarter and -7.84% in the nine months ended Sept. 30. But compared to the year-to-date -15.36% for the Dow Jones Global index, “hedge funds have provided some level of capital preservation to date … however, all strategies appear to be feeling the pain with market uncertainty at an all-time high,” Oliver Schupp, president of Credit Suisse Index Co. LLC, New York, said in a news release from the company.
Institutional investors are crossing their fingers that their hedge fund investments will protect their portfolios from most of the devastation experienced by global equity markets.
“In general, hedge fund portfolios have performed reasonably well. There may have been some manager-specific issues, but overall the industry did pretty well, until after June 30, that is,” said Roger Fenningdorf, partner and head of manager research at investment consultant Rocaton Investment Advisors LLC, Norwalk, Conn.
“For the period ending June 30, most hedge fund indexes were up anywhere from 7% to 14%. There weren’t many complaints from institutional investors. But one quarter makes a big difference,” Mr. Fenningdorf said.
“The objective of hedge fund investment is to generate market-like returns with less volatility. It’s in a period of extreme volatility like we’re now experiencing when people will see whether the construction of their portfolios actually worked to meet this objective. If you have an equity-sensitive hedge fund portfolio, it’s going to be hard to achieve positive returns,” Mr. Fenningdorf added.
Mr. Fennindorf said it’s too early to tell how much damage the third quarter wreaked on institutional investors’ portfolios or whether CIOs are shifting hedge fund weightings tactically to adapt to market conditions or requesting significant redemptions.
Large-scale market information about net hedge fund flows isn’t available yet for the third quarter, but “performance and market volatility (have) impacted investor sentiment,” Peter H. Laurelli, vice president of eVestment Alliance LLC, Marietta, Ga., said in an e-mail.
According to eVestment Alliance calculations, performance losses in September decreased hedge fund industry assets overall by an estimated $64.2 billion, and net redemptions took another $13.4 billion out of the hedge fund market.
“We have seen a definite trend between performance and redemptions/liquidations. Losses in May 2011 led to … net redemptions two months later in July,” for example, he said.
“For reference on how quickly – or slowly – (investor sentiment) can shift direction, after the height of the financial crisis (in 2008), it took four months of positive performance until allocations again began to outpace redemptions.” Mr. Laurelli wrote.
He said that “this time around,” investors are more likely to remember how much of the investment opportunities they missed right after the events in 2008 because they had pulled out of the market. That memory likely will prevent “outflows from persisting and result in net allocations sooner than history would have us believe,” Mr. Laurelli added.