From the March 2006 issue of Investment Advisor • Subscribe!

March 1, 2006

A Bright Start for '06

Hedge funds brought in just under $47 billion in new assets in 2005, which combined with investment performance pushed the industry to a record $1.1 trillion in assets under management, according to Hedge Fund Research Inc. In the fourth quarter of 2005, however, the picture dimmed. Hedge funds experienced a net outflow of $824 million in assets in the period, resulting in the first single-quarter industry-wide asset decline in more than 10 years.

Funds of funds were hit particularly hard, with net asset outflows of $2.1 billion in the fourth quarter, the second quarter in a row that funds of funds' assets declined. The third quarter saw net outflows of $1.2 billion. For the year, funds of funds gained $9.5 billion in new assets; however, that growth rate was 71% lower than in 2004, when funds of funds brought in $33 billion. Funds of funds' 2005 inflow number represented an 84% drop from 2004's $59.4 billion inflow, according to HFR.

The roughly $47 billion in new assets that investors gave to hedge fund managers overall in 2005 represented a 36% decline from 2004, when the industry saw $73.6 billion in new money. Including performance, hedge funds added $132.4 billion in 2005, down from 2004's total growth of $148 billion.

Good news seemingly came at hedge fund managers from all directions in January. Equity market returns were up as was volatility, emerging markets showed gains, and there was big merger news on which to trade.

As a result of all that and more, there were big gains for January, with the Standard & Poor's Hedge Fund Index returning 2.01%.

January was a good month for just about everyone except bond managers. Broad equity indexes rose fairly substantially; the S&P 500 stock index total return was 2.65%, while the Dow Jones Industrial Average was up 1.38%. Equity long/short managers in the S&P Hedge Fund index saw a 4.48% gain.

The S&P Arbitrage Index rose 1.37% in January, with the three underlying strategies--equity market neutral, fixed income arbitrage, and convertible arbitrage--all posting gains. "Equity market neutral managers had a good month with their growth and earnings revision factors the main drivers of performance,"said Charles Davidson, senior hedge fund specialist at S&P.

Fixed income arb managers in the S&P index earned positive returns despite mid-month reversals in interest rates, according to S&P. Convertible arb managers struggled in 2005 as performance lagged historical returns and investors pulled out capital. But the decline in the amount of assets, combined with an increase in equity volatility, favorably impacted January's returns, S&P officials said.

Event-driven managers in the S&P index gained 2.57% in January. Distressed managers used a market rally to exit some of their equity holdings that they acquired during bankruptcy processes, according to S&P, and special situations managers professed optimism about the environment for their strategy "as increased deal activity from cash-rich corporate and financial acquirers raised the probability of faster position turnarounds."

The S&P Directional/Tactical index rose 2.1% in January thanks to long-equity market exposure among the three underlying strategies. Managed futures were up 0.99%.

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 question about hedge funds? Feel free to contact Jeff Joseph by e-mail at jjoseph@rydexfunds.com.

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

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