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Hedge funds

Fixed-income hedge fund assets emerge on top

Institutions led trend in diversification move after crisis

Long/short equity hedge fund strategies lost industry dominance for the first time in 2012.

Assets invested in fixed-income hedge funds exceeded those invested in equity strategies as of Nov. 30 for the first time thanks to a four-year growth spurt fueled by institutional investors.

Fixed-income/credit hedge funds managed an aggregate $796.9 billion as of Nov. 30 compared with $788.9 billion invested in equity strategies, according to data from eVestment Alliance LLC's hedge fund database.

Long/short equity hedge fund assets accounted for 56.32% of total industry assets of $490.6 billion at the end of 2000, according to data prepared for Pensions & Investments by Hedge Fund Research Inc.

Nearly 12 years later, it's clear the breakdown of hedge fund industry assets has essentially equalized.

As of Sept. 30, for industry assets of $2.192 trillion, assets invested in equity hedge and relative-value funds (the best proxy for fixed-income and credit strategies) were equal at 26.7% each, followed by event-driven and macro strategies at 24.5% and 22.1%, respectively, according to HFR data.

Sources said the beneficiaries of the rotation of institutional money into credit/fixed-income hedge funds since the credit crisis of 2008-2009 include BlueMountain Capital Management LLC, Pine River Capital Management LP, Marathon Asset Management, MKP Capital Management LLC and Brigade Capital Management LLC. These firms all have seen significant, multibillion-dollar inflows from pension funds, especially public pension funds, since the end of 2008.

Sources said the most recent market crash forced many institutional investors to reconsider hedge fund portfolio construction and to reduce the weighting to equity strategies just as enormous opportunities were arising in credit markets, an area prime for hedge fund plunder.

“Many pension funds don't want to go through another 2008 and have been very actively diversifying their portfolios over the past four years, seeking volatility reduction as much or more than returns,” said hedge fund consultant and third-party marketer Donald A. Steinbrugge, managing member at Agecroft Partners LLC, Richmond, Va.

That diversification came at the expense of long/short equity strategies, Mr. Steinbrugge said.

Much of the post-crash diversification of institutional hedge fund portfolios also was driven by investors moving from hedge funds of funds to direct investment in single and multistrategy hedge funds, said Peter H. Laurelli, vice president-research based in the New York office of eVestment Alliance.

“Hedge funds of funds pushed more money toward long/short equity (strategies) than most institutional investors were comfortable with,” Mr. Laurelli said, adding that “as investors got out of hedge funds of funds and into direct investment in hedge funds, they applied the same portfolio diversification processes they use for traditional strategies.”

Pine River Capital Management, Minnetonka, Minn., is a good example of one of the credit specialist hedge fund firms that began to attract serious institutional investment after the credit crash.

Pine River launched its first fund in 2002 with about $5 million, and total assets for the firm before 2008 peaked at $1.3 billion, said Brian Taylor, Pine River's founding partner, CEO and chief investment officer. By the end of 2012, assets had risen to $11.6 billion — almost exclusively from institutional investors.

Pine River is a mortgage specialist among other things and “the mortgage and credit markets were at the epicenter of the devastation in 2008,” Mr. Taylor said, noting it took “a huge amount of education, the hiring of investment product specialists, and a lot of time on the road in 2009, 2010 and 2011 explaining to institutional investors what great opportunities there were in these markets.”

“Crisis creates opportunities and, given our inflows, we felt like we should really ramp up our New York office where many of these opportunities were,” Mr. Taylor said. More employees worked at Pine River's Minnesota headquarters pre-crash, but now more people and investment activity are based in New York.

Performance not helping

Annual performance hasn't helped equity hedge fund managers hang onto their investors, sources said, as it trailed that of fixed-income/credit funds in every year beginning with 2008. The one-year return of the HFRI Equity Hedge index in 2008 was -26.65%; for 2009, it was 24.57%; 2010, 10.45%; 2011, -8.38%; and 2012, 7.39%. By contrast, the one-year return of HFRI Relative Value in 2008 was -18.04%; 2009, 25.81%; 2010, 11.43%; 2011, 0.15%; and 2012, 10.04%.

The Standard & Poor's 500 index returns were better than the equity hedge fund index in each of the five years 2008 to 2012.

While plenty of institutional investors continue to pour money into credit hedge funds, poor prospects for long-only fixed income are pushing many to look for investments that will help them meet their assumed rate of return.

At the same time, a resurgence in the importance of fundamentals in equity valuations have raised expectations for a long/short equity comeback in 2013.

Sources report that institutional investors already are placing their long/short equity bets, with both the $157 billion Florida State Board of Administration, Tallahassee, and the $3.4 billion Colorado Fire & Police Pension Association, Greenwood Village, making investments in January of $200 million and $30 million, respectively, in Scout Capital Partners II LP.

“There is definitely a rotation going on from fixed income to equity within the hedge fund markets, driven by conviction that fixed-income returns won't do well enough to meet institutional investors' return expectations,” said Warren Wright, principal, chief investment officer and co-founder of Diversified Global Asset Management Corp., Toronto, which managed US$6 billion in hedge funds of funds as of Dec. 31 for institutions.

Agecroft's Mr. Steinbrugge agreed, noting the huge influence of macroeconomic factors on stock valuations is beginning to reverse, creating a more rewarding environment for fundamental stock pickers.

Mr. Wright agreed that while “the macro noise has been deafening over the past few years, it is beginning to subside,” but noted long/short equity managers will need “the right environment, including returns dispersion between equities, enough volatility to create opportunities and sector opportunities.” If all of these factors align this year, Mr. Wright said DGAM analysts expect long/short equity managed to return 6% to 7% in 2013.

Fundamental equity manager Lee S. Ainslie III, managing partner of Maverick Capital Ltd., New York, brought in a strong 16% return for the firm's flagship long/short equity strategy in the year ended Sept. 30, according to Bloomberg.

Declining to comment on his fund's performance, Mr. Ainslie did admit cautious optimism for 2013, stressing “stock valuations can diverge only so far from the fundamentals.”

He doesn't believe he is alone in that opinion.

“I think there is a crowd of institutional investors who are beginning to believe that the challenging headwind long/short equity managers have been facing will diminish soon and are saying `I want to be there,'” Mr. Ainslie said.

Maverick Capital managed $9 billion as of Dec. 31, and investor inflows are “positive. Not a tsunami, but steady and positive going into the first quarter,” he said.

This article originally appeared in the January 21, 2013 print issue as, "Fixed-income hedge fund assets emerge on top".