From the August 2005 issue of Investment Advisor • Subscribe!

August 1, 2005

Institutions Are Still Committed

Two recent surveys provide insights into the current state of hedge funds and their longer-term performance.

In the first, an annual investor survey by Deutsche Bank's Hedge Fund Capital Group highlights long-time investors' commitment to hedge fund allocations despite their acknowledgement that double-digit returns are no longer realistic.

The 2005 Alternative Investment Survey surveyed 650 institutional investors, and found that 68% predicted that hedge fund returns will total between 6% and 8% in 2005. The same percentage think the record asset inflows of the past few years were the primary factor contributing to lower performance expectations.

The growth of inflows appears to be decreasing, however. Deutsche Bank estimates that current hedge fund investors will add another $40 billion to the industry this year, which is significantly lower than TASS Research's estimates of 2004 inflows of $123 billion.

The largest investments into hedge funds come from funds of funds, but banks, insurance companies, corporations, and consultants are enlarging their hedge fund portfolios. An increasing number of corporations in particular are making hedge funds a part of their treasury operations portfolio.

The average size of a hedge fund investment is on the rise and now stands at $19 million, while corporations and the like allocate $26 million at a clip, with the median number of allocations per year totaling 12. Funds of hedge funds make the most frequent allocations to hedge funds (roughly 15 per year), averaging $19 million at a time.

Investors with more than $5 billion under management will likely increase their hedge fund investments by 2% this year, the Deutsche Bank survey found.

John Dyment, global head of the Deutsche Bank group, reported "a marked slowdown of capital in the asset classes, a phenomenon that only started to accelerate in the last quarter." He said that if hedge funds start to see months of good returns that trend could reverse.

In terms of total assets, the most popular strategy remains long/short equity, with 68% of survey respondents reporting they are using that strategy and most expecting it to be the top performer for the year. Event-driven, multi-strategy, and distressed were also popular strategies.

Most investors indicate they will make additional allocations to global macro (59%), long/short equity (58%), and event-driven funds (55%).

Higher Sharpe Ratios

Many hedge fund strategies have higher returns and lower volatility than stocks and bonds after the data is adjusted for distortions, a Merrill Lynch study, Introduction to Hedge Funds, has found.

The report, written by Anil Suri, shows that in the long term, six strategies--merger arbitrage, convertible arbitrage, equity market neutral, distressed securities, equity hedge, and global macro--had higher adjusted Sharpe ratios compared with both the S&P 500 and the Merrill Lynch fixed-income index.

Interestingly, convertible arbitrage was the second-best long-run performer by the adjusted measure. The strategy has been in the red this year, and some investors have responded by withdrawing their money.

In terms of unadjusted compound annualized returns, only equity hedge, distressed, and the composite beat the S&P 500 for the entire period. But for the past five years, with the bear market of 2000-2002 included, all hedge fund strategies did better than the S&P 500.--Jeff Joseph

Jeff Joseph is managing director of Rydex Capital Partners and serves on the advisory board of HedgeWorld (www.hedgeworld.com), a global provider of hedge fund information and investment products.

Have a hedge fund question? Contact Jeff Joseph at jjoseph@rydexfunds.com.

For inquiries about HedgeWorld's services, e-mail inquiry@hedgeworld.com.

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