Hedge funds posted their first inflows in nine months (see BarclayHedge article, free registration required). Based on a survey of over 1,200 hedge funds, it is estimated that the hedge fund industry gained $1.4 billion in May, or 0.1% of total assets. Nonetheless, funds-of-funds and CTAs are still experiencing outflows. Fund-of-funds, which did not do as good a job as expected picking hedge funds in order to justify their extra layer of fees, lost $5.2 billion, or 1.0% of assets in May. This makes their twelfth straight monthly outflow. Below is the hedge fund asset flow data by strategy for May 2009 (source: BarclayHedge, see article, free registration required). Next to fund-of-funds and managed futures, event driven strategies saw the biggest outflows. Equity long-short, fixed income, and multi-strategies saw the biggest inflows.

Hedge funds had a nice May, up 5.2 percent on average. While the recent market rally no doubt helped, hedge funds also appear to be benefiting from less competition (see Economist article), with approximately 1,500 funds liquidating last year. This follows a similar trend observed in the late 1990s when less competition for trading opportunities helped those funds that survived after the LTCM failure.

But as reported in the article, not everything is rosy. After poor performance in 2008, many investors are requiring a more fair fee structure, one that is either closer to 1-10 (instead of 2-20), or that phases in fees over a longer period, after the fund has outperformed a benchmark - with the benchmark closer to the general market, and not simply zero, or a non-negative return. Investors also seem to be asking for more managed accounts where they can see where their money is being invested, and can also withdraw it quicker (and without gate restrictions). If that was not challenging enough, one cannot forget the added government regulation is coming down the pike. Possibly the biggest loser will be the funds-of-funds, which tack on an extra level of fees for the expertise of picking the best funds. Their failure to outperform enough to compensate for the extra fees, along with the benefits of cheaper hedge fund replication clones (see previous posts here, here, here, and here), are also making their services less cost effective.

Interesting post over at the AllAboutAlpha site that is worth the read. The post discusses how even if a hedge fund has stop reporting returns, this does not imply that the fund is dead and closing up shop after blowing-up in the recent market downturn. As it turns out, only about a fifth of the funds (according to the study) stop reporting because they are liquidating. Others simply have stopped taking on new investors, or have other reasons for not reporting returns. Of interest in the article is how the researchers studied fund-of-funds to estimate (guess) what the returns are of those funds that have stopped reporting (given that their performance is still showing up in the fund-of-funds that do report). Not surprising, while the "dead" funds that no longer report returns did perform worse than those that did report, the level of losses were close to -3%, and not in the category of "blown-up." While many funds may still go under (in part due to it now taking too long to reach high water marks after significant losses), the reports of the death of hedge funds may be greatly exaggerated.

The Swiss funds-of-funds firm Gottex Fund Management is launching a new fund that will emulate the investments and strategies of some of the larger U.S. academic endowment funds, such as those at Harvard and Princeton (see the HedgeFund.net article). The new Gottex fund will also allocate around 65% of the fund to alternative investments. Why 65%? When preparing the fund, the Gottex group found that a 65% exposure to alternative investments, when combined with traditional investments, did the best over the long-term. No indication if that means risk-adjusted or not. As for the alternative investments, everything from hedge funds, private equity, long-only equity, commodities, fixed income, real estate, and other real assets will be utilized. Given the current environment, the timing could prove advantageous. As mentioned by fund manager William Landes, "For the short-term the challenging environment for alternative products like private equity and hedge funds was where the opportunities lie. If I put my investor hat on, I would say that if I have a six to nine-month tactical horizon, global equity markets and some alternative markets are actually where I want to be.” Given the move by many academic endowments towards greater exposure to real assets, commodities, private equity, and international equities, any new fund emulating the likes of the Harvard fund may offer no other choice.

Data from HedgeFund.net appears to show that emerging hedge fund managers, defined as those with a track record of less than three years and fewer than $300 million in assets under management, are doing better than their more established colleagues by generating returns that are 3% to 4% higher per year. Beside being more flexible in volatile markets due to their smaller capital structure, another possible reason for emerging fund out-performance appears to be that institutional investors are increasing their allocations to newer and smaller hedge funds, according to a report from the hedge fund group Infiniti Capital. This appears to be in contrast to previous reports (see Economist article, and previous post) that smaller hedge funds were having trouble raising capital and were subsequently being pruned from the industry as institutional investors and pension funds looked for the safety of larger, more established funds and managers. Either the data and analysis are incorrect, or a shift is occurring as institutions come to the realization that bigger is not always better, especially for those institutions investing in fund-of-funds which are more likely to generate returns closer to the market averages, while at the same time providing another layer of management fees.

There is an interesting article over at the Economist regarding hedge fund returns. As pointed out in the article, hedge funds had a great first half of 2008 when compared to standard benchmark indexes, outperforming Wall Street by 12%. On the other hand, given that the market lost slightly more than this on average, you could also say that hedge funds did poorly during the first six months, producing what amounted to their worst return on record. So which is it? It really depends on your perspective. Interestingly, if your mutual fund beat the market by 12%, even in a losing year, you would probably feel pretty lucky. Yet with hedge funds we expect more. We want that 30% per year, regardless of the market. After all, that is why we pay the 2-20, in good times and bad. We want returns that are uncorrelated, regardless of the market return (yes, I know, it does not always make sense).

Also of interest in the article, and something talked about before, is the pruning of hedge funds, or at least a slowdown in the net growth of new funds. The trend of the bigger getting bigger is continuing. The question is whether this will be good in the long run. As more and more pension, retirement, and endowment funds invest in hedge funds, the tendency to invest in more "stable," i.e., larger hedge funds will increase. Not only will fund-of-funds increase as institutional clients enter the industry, but this trend will produce a combination of fees upon fees, along with large diversified portfolios producing more mediocre returns. After all, a nice $500 million hedge fund can focus investments in, say, small or mid-cap banks, looking for opportunity and then taking a large position compared to totals assets. This is more difficult for the larger funds, resulting in more diversification and mediocre returns. As funds start looking and performing like mutual funds with flexibility (shorting, leverage, etc.), justifying the 2-20 may become even harder for some funds.