Asset Flows and Industry Trends
Allocators to the industry sent $23 billion of net new capital into hedge funds during the quarter, bringing total industry assets to over $2.5 trillion. Investors continue to exhibit a bias towards the large, institutional-quality funds as 80% of this net new capitalflowed to managers who oversee more than $5 billion in assets under management.
Hedge Fund Performance
For the quarter, the hedge fund industry returned +2.34% (YTD +5.63%). Our Candidate Funds outperformed the overall industry with a return of +2.63% QTD (YTD +7.60%).1
Top performing Candidate Funds for the quarter were those pursuing event driven (+7.77% QTD, +10.97% YTD), long/short equity (+5.46% QTD, +16.63% YTD), and distressed (+3.89% QTD, +9.89% YTD) strategies.
2013 Investment Themes
Growth prospects in Europe have turned positive and capital market activity has begun to resurface, which has generally resulted in a more constructive view of the opportunity set in the region. Several credit Candidate Funds have expressed interest in exploiting opportunities within the municipal bond market and the Commonwealth of Puerto Rico. A number of Candidate Funds continue to cite the opportunities in Japan and are spending an increasing amount of time on the ground in the region.
Asset Flows & Industry Trends
For the third quarter of 2013, asset flows into the hedge fund industry accelerated at their fastest pace since the second quarter of 2011. Allocators to the industry sent $23 billion of net new capital into hedge funds during the quarter, bringing total industry assets to over $2.5 trillion. Investors continue to exhibit a bias towards the large, institutional-quality funds as 80% of this net new capital flowed to managers who oversee more than $5 billion in assets under management. Among the various hedge fund strategies, equity-hedged managers witnessed inflows of over $10 billion for the quarter, allowing it to regain its spot as the largest hedge fund strategy with $686 billion. In addition, event driven and relative value arbitrage strategies also saw sizeable inflows for the quarter.
Hedge Fund Performance
During the third quarter of 2013, the hedge fund industry, as represented by the HFRI Fund Weighted Index, returned +2.34%, bringing YTD returns to +5.63%. Our institutional-quality Candidate Funds outperformed the overall hedge fund industry by generating a quarterly return of +2.63%, which brings YTD performance to +7.60%. For the quarter as a whole, the broad equity markets continued on their QE-induced upward march. However, periods of intraquarter uncertainty—relating to U.S. monetary policy and geopolitical concerns—reiterate the importance of including less correlated assets into an overall asset allocation mix. For instance, while the S&P 500 fell over -3% in the month of August, hedge funds were able to generate 246 basis points of outperformance for the month. By definition, hedge funds are “hedged” investment vehicles that are generally tasked with delivering attractive riskadjusted returns in a manner that is typically less correlated to movements in the overall market. As a result, managers in the space are able to offer downside protection in periods of stress but, due to these principles, should not be expected to fully participate in unabated market rallies.
LONG/SHORT EQUITY – For the quarter, long/short equity Candidate Funds were largely able to extract returns in the Diversified Financials, Consumer/Retail, Information Technology, and Energy sectors. Managers within the space who held higher levels of exposure outside the U.S.—particularly Japan—also saw meaningful returns for the quarter.
EVENT DRIVEN – With their general long bias, event driven Candidate Funds led all other strategies in generating returns for the quarter. While M&A activity has tracked upwards, spread levels for uncontested deals continues to be rather underwhelming and has resulted in exposures to announced deals to be somewhat light. One manager theorizes that spreads on announced deals will increase to more attractive levels once interest rates begin to normalize from these historical low levels. Nevertheless, event driven Candidate Funds have focused on transactions that incorporate some form of complexities, as well as attempting to uncover potential takeover opportunities in the marketplace. As a whole, event driven managers continue to emphasize positions with defined events and catalysts associated with them. In addition, event driven managers have begun to take a more active role in order to drive outcomes in select portfolio names. For instance, in order to effectuate change, Daniel Loeb’s Third Point initiated an activist campaign against the auction house Sotheby’s during the quarter.
GLOBAL MACRO – Global macro Candidate Funds faced headwinds in the third quarter and the trading environment proved to be rather difficult. By and large, the trading in rates benefited the portfolios of a number of Candidate Funds and those managers with heightened equity exposure seemed to amplify their returns relative to others in the space. Global macro managers investing in the Japan reflation trade were disappointed in July and August as equity markets in the region sold off. However, Japanese equity markets concluded the quarter on a positive note, up 8% for the month of September. With regards to FX exposure, those managers who were long the USD on the basis of U.S. growth prospects and/or potential Fed tapering were hamstrung for the quarter.
CREDIT – Distressed Candidate Funds continued to uncover opportunities during the quarter and proficiently added to their YTD gains. Managers in the space continue to generate gains from the Lehman Brothers estate, in which one Candidate Fund believes an 8% to 13% estimated return is possible moving forward based on timing and the amount of future distributions. In addition, the airlines industry continues to be a theme for a number of distressed Candidate Funds, with one manager acknowledging that they increased their position in the AMR bankruptcy following the DOJ’s suit seeking to block the merger transaction with US Airways. Also, a number of Candidate Funds saw further gains in Argentinian sovereign debt for the quarter. Managers pursuing the distressed credit strategy also continued to benefit from increased activity in Europe as a number of Candidate Funds were involved in the government-led capital raise of Greek bank Piraeus. For the quarter, convertible valuations richened and spread levels continue to be wider than historical levels. Lastly, several managers have commented that while the housing market is healthy, the non-agency MBS trade from 2012 has likely run its course. As a result, managers have shifted their targets elsewhere with one Candidate Fund during the quarter purchasing a residential non-performing loan pool at a substantial discount where they will work with the homeowners in order to find mutually beneficial workout solution.
MANAGED FUTURES – Candidate Funds within the managed futures strategy posted mixed results for the third quarter. In July, several Candidate Funds benefited from a long bias in equities but a short bias in gold and cooper and moves in the FX markets detracted from returns. In addition, a rally in energy hurt the performance of one manager and a sharp reversal in European Bund futures detracted from returns for another manager. For August, the reversal in equity markets contributed to losses, as well as moves within the precious metals complex. While long equities benefitted the portfolios of multiple Candidate Funds in September, there was some dispersion in returns as a long exposure in energies detracted meaningfully from one manager’s performance for the month.
2013 Investment Themes
Going into year-end, Candidate Funds are optimistic about the investment environment ahead but they also remain fairly cautious. In this part of the cycle, many multi-strategy managers prefer equities to credit markets and select credit managers are beginning to hold higher than average equity exposure. However, managers in the credit space realize that an eventual normalization of rates will likely lead to another cycle supportive of their activities. In the meantime, several credit Candidate Funds have expressed interest in exploiting opportunities within the municipal bond market and the Commonwealth of Puerto Rico. While structural reforms in Europe are still somewhat lacking, growth prospects have turned positive and capital market activity has begun to resurface, which has generally resulted in a more constructive view of the opportunity set in the region. Nonetheless, some Candidate Funds still recognize that downside risks are still present and continue to hold a long volatility position. Finally, a number of Candidate Funds continue to cite the opportunities in Japan and are spending an increasing amount of time on the ground in the region. Although markets have advanced meaningfully YTD and some participants have voiced the need for more concrete structural reforms, one manager noted that the region still offers attractive investment opportunities due to valuation levels and company-specific attributes.
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CITATIONS AND DEFINITIONS: 1 Candidate Funds – Institutional-quality hedge funds that are offered through Crystal Capital Partners and that are available for inclusion in a custom hedge fund portfolio. The CCP Indices represent pro forma portfolios for each Fundamental Strategy where equal weight is given to every Candidate in the Strategy. Please see complete pro forma disclosures at the end of this document. 2 “Global Hedge Fund Industry Report for Q3 2013.” https://www.hedgefundresearch.com/pdf/pr_20131018.pdf “. Hedge Fund Research, Inc., Q3 2013 3 The HF indices included in this analysis are the DJCS, HFRI and HFRX.