Hedge fund inflows continue despite tepid index returns

Low hedge fund index returns in 2014 did little to dissuade investors from increasing their hedge fund portfolios and masked a hefty performance divergence among hedge fund managers and strategies.

The hedge fund industry last year endured widespread public criticism about disappointing returns relative to the Standard & Poor's 500 index and high fees.

Industry tracker Hedge Fund Research Inc., for example, reported that its flagship index, the HFRI Fund Weighted Composite returned 3.3% for the 12 months ended Dec. 31, compared to 9.1% in 2013 and 6.4% in 2012.

Other major hedge fund indexes reported similar aggregate returns from their databases for 2014, with the Preqin All-Strategies index at 3.8%; Barclay Hedge Fund index, 3.2%; and eVestment Hedge Fund Aggregate index, 2.8%.

The S&P 500, by contrast, was up 13.7% in 2014; the MSCI All-Country World index, 4.8%; and Barclays Capital U.S. Aggregate Bond index, 6%.

“It really was a better year than the numbers show, given that the equity market spent most of the year at record highs,” precisely the type of environment when many hedge fund managers become “conservatively positioned” and focused on downside protection, said Kenneth J. Heinz, president of Chicago-based HFR.

On an asset-weighted basis, the same universe of 2,200 hedge funds HFR tracked produced an aggregate return 200 basis points higher than the fund-weighted composite, Mr. Heinz said.

There were “powerful, significant differences” in returns between the largest hedge funds in the industry, those managing $15 billion or more, and the rest of the HFR universe, Mr. Heinz said.

“Experience played very well for some of the largest hedge fund managers who have been through markets like this before. What's more, those firms tend to be favored by institutional investors,” he said.

There was a 120-basis-point difference between the 3.5% return of large funds managing more than $1 billion in eVestment's Hedge Fund Aggregate index and the 2.3% return of funds in the universe managing less than $250 million, for example, said Peter Laurelli, New York-based vice president and head of research at eVestment LLC.

But sources said the prolonged upward trajectory of the S&P 500 worried many investors — especially institutions — enough to push them to increase their hedge fund investments.

As a result, hedge fund assets rose 8.3% in 2014 to reach $2.85 trillion, an industry high, HFR analysis showed.

Net hedge fund inflows were $76.4 billion in the 12 months ended Dec. 31, the highest annual total since $194.5 billion of net inflows in 2007. Total net inflows in 2014 were up 19.9% over the prior year.

Institutional investor net inflows into hedge funds and hedge funds of funds in 2014 were up 19.6% to $9.6 billion, according to an analysis of hiring and termination activity in Pensions & Investments' P&IQ database. The actual net inflows likely were much higher last year because the database does not track additional contributions to existing hedge fund managers, which were considerable, based on P&I reports.

Among institutions investing in hedge funds and funds of funds in 2014:

nthe $23.4 billion Texas Municipal Retirement System invested $1.1 billion with one manager;

nthe $129 billion Teacher Retirement System of Texas invested $1.037 billion in nine funds;

nthe $11 billion International Association of Machinists and Aerospace Workers National Pension Fund invested $1 billion with one manager; and

nthe $178.8 billion Florida State Board of Administration invested $950 million in seven strategies.

HFR's data showed that in addition to inflows, hedge fund assets also were propelled to the industry record by $140.3 billion of performance gains in 2014.

Asset growth by strategy in 2014 was led by relative value with a total of $75.2 billion, of which $45.5 billion was from net inflows and $29.7 billion from investment gains. Event-driven strategies totaled $56.2 billion for the same period, with $32.1 billion from net inflows and $24.1 billion from returns; equity hedge had $54.6 billion, with net inflows of $26.8 billion and returns of $27.8 billion.

The high investment gains of $58.8 billion for HFR's global macro category, on the other hand, were checked by high net outflows of $28 billion in the year.

Sources said it wasn't surprising that some investors pulled their assets from both global macro and managed futures managers/commodity trading advisers in 2014 because strategy index returns were universally negative in each of the three prior years.

But trend-following, non-discretionary CTA managers, especially large firms, began to show markedly better performance beginning in August, when global market volatility began to pick up, data from hedge fund index manager BarclayHedge Ltd. showed.

For example, monthly returns of the Barclay BTOP50 index — an investible index that replicates the overall composition of the managed futures industry using open funds managing at least $1 billion — moved into positive territory in August with a 2.6% return after months of flat or negative returns. By year's end, the BTOP50 index had recovered to return 12.3%.

“CTA managers were the big surprise in terms of returns in 2014. No one would have predicted such strong returns from this hedge fund category at the beginning of the year,” said Alex Da Costa, Montreal-based director of hedge fund research and consulting at Pavilion Advisory Group Ltd.

Systematic, non-discretionary CTA managers as a group best demonstrated the difference in returns between large and small hedge fund managers, said Sol Waksman, founder and president of BarclayHedge, Fairfield, Iowa.

For example, the Barclay CTA index, which includes all global macro and managed futures funds in BarclayHedge's database, returned 7.7% for the year ended Dec. 31. The 12.3% return of the 20-fund investible Barclay BTOP50 index subset was 460 basis points higher than the broad index. A further division of the index to reflect only one-year returns of the 12 non-discretionary trend-following CTA managers in the BTOP50 showed a return of 19.6%, a 730-basis-point improvement on the full BTOP50 index and a whopping 1,190 basis points over BarclayHedge's basic CTA index.

Mr. Waksman was less sanguine than HFR's Mr. Heinz, however, about the element of experience and wisdom of larger managers, even managed futures specialists, in producing outsized returns in 2014.

“Everyone has been tinkering with the systematic model for eons. This year, given the way global macro trends moved the markets, it was really a matter of the manager's timing and good fortune as to who made the most money,” Mr. Waksman said. n