NICK EVANS, EDITOR, EUROHEDGE
If, as many people suspect, 2012 could prove to be a make-or-break year for hedge funds in Europe after the problems of the past few years, then the jury is still firmly out as to which way the verdict will go.
The evidence is decidedly mixed. Performance has been patchy, overall industry growth is weak, institutionalisation continues to drive ever-greater asset concentration and new fund launches have fallen to the lowest levels on record.
And yet the quality of the new funds coming through in Europe is higher than ever, investors remain keen to allocate to hedge funds (both established and emerging), the shutdown rate has returned to pre-crisis levels after its post-crash spike and there is a growing belief that Europe will – at some point – present extraordinary investment opportunities.
Two thirds of the way into a year where the market, macro and regulatory environment has again provided a very unsettled backdrop for most strategies, European hedge funds are at least holding their heads above water in terms of overall performance.
To the end of July, the EuroHedge Composite Index was up by 2.14% on a median basis and just over 2.5% on a mean average basis – with credit and convertible arbitrage the best performing strategies, with average returns of 7% and 6%, respectively.
Most funds have done a reasonable, if not brilliant, job of combining return generation with downside protection in conditions that remain very testing – with the eurozone crisis acting as a permanent source of uncertainty and potential disaster.
And there have been many strong individual performances, with several funds notching up some eye-catching returns in long/short equity, macro, credit, fixed-income, event-driven, multi-strategy, convertibles, managed futures, FX and volatility trading.
But the first half was a game of two quarters – with markets becoming increasingly tricky in Q2 after a buoyant start to 2012. And the pressure on managers is still intense to deliver genuine alpha and robust risk-adjusted returns at a time when many investors are starting to question their whole attitude towards hedge funds after the disappointments of 2008 and 2011 – and in markets that continue to veer sharply from risk-on to risk-off.
So far, the numbers suggest that investors are broadly keeping faith with their hedge fund investments – with redemptions and outflows running at subdued levels, although they have shown signs of starting to tick up through the summer months.
OVERALL ASSETS REMAIN STRONG
Given the overall negative performance last year, it was impressive that overall assets in European hedge funds remained as strong as they did in 2011 – rising a little to $425 billion by the start of this year.
New money is still coming into the industry generally – particularly into managed futures and macro strategies – and there is growing interest from global investors (notably in the US) in the opportunities that the European crisis will create, especially in distressed credit but also in equity-related strategies.
But there is also growing evidence that some other investors are starting to call time on hedge funds, or at least cut back their commitments, after several years of disappointing returns and unfulfilled expectations.
The rising correlation of hedge fund performance with underlying markets has led some clients to query whether managers are delivering the portfolio diversification they need. Conversely, the high level of performance dispersion within specific strategy areas has highlighted the difficulty in picking individual managers.
The dispersion so far again this year between the best and worst performing funds is striking: from +25% to -10% in European long/short; from +30% to -15% in global equity; from +25% to -15% in global macro; from +20% to -15% in managed futures; and from +15% to -20% again in event-driven.
Further adding to the air of uncertainty overshadowing the industry in Europe is the raft of new regulatory and compliance requirements coming down the line – which will impose a whole new layer of cost and administrative hassle to managers and investors (and service providers too).
All this macro, market and regulatory uncertainty is clearly acting as a severe restraint on new fund launch activity – which has now fallen to its lowest level in Europe in more than a decade.
Just 37 new hedge funds launched in the first half of the year, raising $3.6 billion – a massive drop from the peak years of 2004 to 2008, when well over 100 new funds were launched in the first half every year.
QUALITY NOT QUANTITY
Despite the plunge in quantity, the quality of the new European funds coming through is exceptionally high – both in terms of the investment pedigree of the principals and (as importantly) the strength of the supporting business infrastructure.
Bank prop trading spin-outs continue to be a major source of the new entrants, together with a growing number of experienced ‘second generation’ managers from leading hedge fund firms who are launching their own operations.
And, although the bar for new funds rises ever higher in line with the institutionalisation of the industry, there is also more money available for seeding and early-stage investment than ever before – and from an increasingly diverse range of providers.
Dedicated seeders, family offices, funds of funds, banks, private equity groups, insurers and even pension funds and other institutional investors themselves are all increasingly keen to back some of the new generation of hedge funds that could well be the stars of tomorrow.
The pipeline for new hedge fund launches in the rest of the year looks strong. And arguably there has never been a time when new blood is needed more urgently in the industry than it is now.
But managers, whether established or emerging, need to deliver. Investors are getting restless and they need results. Just as in Europe as a whole, where the crisis could just as easily develop into either a full-blown catastrophe or a golden opportunity, so the European hedge fund industry could be at an inflection point too. And its prospects over the next few years may depend largely on its performance over the next few months.