Hedge fund managers fail to deliver in 2008

Investors lost their appetite for hedge funds in 2008, as the vehicles intended to deliver absolute returns were forced to resort to relative claims of success. Since August 2007--the beginning of the credit crunch--hedge funds have effectively acted as muted versions of equities, providing positive returns only twice when the MSCI World Stock Index was negative. Still, the Morningstar 1000 Hedge Fund Index did outperform the MSCI World Index by a sizable 20 percentage points for 2008, thanks in part to large cash allocations.

Investors redeemed assets aggressively in 2008. Hedge fund inflows peaked in June 2007 and bottomed in October 2008, when more than US $21 billion left the industry. In November 2008, another US $19.4 billion flowed out of hedge funds, setting the year-to-date outflows at more than US $44 billion.

Hedge fund investors showed a strong tendency toward performance chasing, investing more after positive months and withdrawing assets after down months. Investors following this strategy ended up losing less than the index, as the markets trended increasingly downward as the year progressed. High redemptions and little possibility of collecting performance fees in the near future led hedge funds to shutter in record numbers in 2008. The number of funds dropping out of Morningstar's database increased more than 150% in 2008 from 2007--1,158 single-manager funds and 490 funds of funds were removed in 2008 compared with 434 single-manager funds and 208 funds of funds in 2007. (Funds are removed from Morningstar's database if the fund liquidates, if the manager wishes to stop reporting returns, or if funds fail to report returns for six months.)

The Morningstar 1000 Hedge Fund Index lost 10.3% in USD terms in the fourth quarter of 2008 and 22.2% for the year, wiping out the last two years of gains. The index bounced back slightly after extreme market illiquidity and volatility in January and March 2008, but since May, hedge funds have been on a steady decline. Massive losses in September and October of 7.9% and 9.8%, respectively, quashed any hope of salvaging the year, even though it ended on a positive note--December posted a 2.1% gain.

Morningstar also calculates hedge fund indexes according to the MSCI methodology. The Morningstar with MSCI Asset Weighted Hedge Fund Composite Index, which hedges U.S. dollar exposure, lost 12.9% in 2008, while the equally weighted version lost 16.4%, reflecting the poorer performance of the smaller funds.

Emerging-markets equities proved to be the worst strategy in 2008. Effectively running a market-return strategy, these funds are only able to invest in stocks or hold cash, as shorting emerging-markets holdings is very difficult. Emerging stock markets performed worse than other markets, as skittish investors pulled capital out of risky assets. Although emerging markets bounced back in December, the MSCI Emerging Markets Index lost almost 55% in 2008 while the Morningstar Emerging Market Equity Hedge Fund Index lost 45.6% in 2008 and 20.7% in the last quarter alone.

The ability to hedge helped the Morningstar with MSCI Developed Markets Hedge Fund Index, which lost only 11.9% in 2008. Of the developed-market equities funds, Europe equity hedge funds fared the best on a relative basis. The Morningstar Europe Equity Hedge Fund Index beat the MSCI Europe stock index by about 30 percentage points in 2008. The Developed Asia Equity Hedge Fund Index also outperformed the MSCI AC Asia Index by more than 19 percentage points. Late in the year, European and Asian hedge funds got some relief, as governments announced rate cuts and stimulus packages, boosting the equity markets.

The best-performing strategy this year was global trend following, a systematic strategy that tracks price trends in liquid derivatives such as futures, options, and currency forwards. The Morningstar Global Trend Hedge Fund Index gained 7.4% in the fourth quarter of 2008 and 9.8% for 2008 overall. In the first half of the year, these funds profited from an upward trend in commodities and a downward trend in the U.S. dollar, as uncertainty over the U.S. economy led to increased investment in "hard" assets. The third quarter saw a sharp reversal in these trends, catching global trend funds by surprise. But these funds recovered in the fourth quarter, as the drop in oil and the rise of the U.S. dollar sustained.

Global non-trend-following funds, which trade the same instruments as global trend funds but in a more discretionary manner, gained 0.9% in the fourth quarter, ending the year down 1.2%--less than every other losing category. These funds benefited from the liquidity of the instruments that they trade, enabling them to get in and out of the market quickly.

Convertible arbitrage funds took a big hit in 2008. The Morningstar Convertible Arbitrage Hedge Fund Index dropped 13.1% over the quarter and 24.9% over the year. In May 2008, convertible bond issuance hit an all-time high as financial firms desperately sought capital. But in September 2008, when these same financial firms' stocks suffered major damage, the Securities and Exchange Commission and Financial Services Authority banned the ability to short them. This caused convertible arbitrage funds, which typically take long positions in convertible bonds hedged with short positions in the related stock, to plunge into the abyss. As convertible bonds continued to be viewed as risky assets, and as yields on risky debt rose sharply, these leveraged funds were subjected to margin calls and forced selling.

Plagued by a similar fate, funds in the Morningstar Debt Arbitrage and Morningstar Global Debt Hedge Fund indexes plunged 8.2% and 18.7%, respectively, in the last three months of the year, and 16.7% and 28.5%, respectively, in 2008, as investors fleeing to Treasuries caused credit spreads to widen to near-Depression-era levels in even investment-grade corporate bonds. Defaults on high-yield bonds rose to a record high in November, thereby squeezing the price of high-yield securities and sending the Morningstar Distressed Securities Hedge Fund Index down 16.1% for the fourth quarter, and 25.3% for the year. Hedge funds buying distressed assets early in the credit crunch saw their investments deteriorate even further alongside the economy.

Poor timing and illiquidity also took a toll on corporate actions funds. The Morningstar Corporate Actions Hedge Fund Index dropped 28.9% in 2008, including 13.2% for the final quarter. These value-seeking funds look for events such as privatizations, mergers and acquisitions, share repurchases, IPOs, and spin-offs to enhance share value, but such events proved scarce during the steep bear market. Tight credit, badly performing equity, and lack of institutional-investor demand turned the leveraged buyout boom, which peaked in mid-2007, to bust in 2008. This year also witnessed the collapse of a record number of merger and acquisition deals and a 50% drop in IPO activity. The easy-credit bubble burst, and along with it a great many hedge funds.