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Overview: Market Neutral Equity Funds
The HFN active and inactive databases contain nearly 400 unique fund products with a primary investment strategy of investing in equity securities while maintaining a neutral market bias. The active commercial database contains 224 products, 60% of which are unique with 7 of the unique products structured as UCITS.
•The HFN Market Neutral Equity Index was +0.58% in April and +1.71% YTD. Returns have trailed the HFN Hedge Fund Aggregate Index by nearly half and are well below the S&P 1200 Global in 2011.
•HFN estimates total market neutral equity (MNEq) fund AUM of $43.9 billion at the end of April 2011. Market neutral fund AUM has increased 2.6% YTD.
•UCITS compliant MNEq funds have underperformed in recent months. A benchmark created for these funds was +0.32% in April, but -1.19% in 2011.
Performance of MNEq benchmarks perhaps is an incomplete portrait of the funds’ performance in recent years. Typically, MNEq funds are not designed to generate large monthly returns, but rather generate stable returns over time regardless of market movements. When many of these products are put together to form a benchmark, the resulting return stream shows little variance and relatively mediocre returns. In the remainder of this report we look more closely at sources of returns and asset flows to gain a better picture of the varying performance and trends of MNEq hedge funds.
Total Asset Levels and Flows
Market neutral equity funds had above average rates of re-demptions during the financial crisis and Madoff scandal. Allocations rose in 2010, but mediocre performance has again left the group with below average investor interest in 2011.
•Total AUM in MNEq funds was $43.9 billion as of April 2011, an increase of 2.6% in 2011 compared to an increase of 5.5% for the hedge fund industry.
•Investors accounted for a net redemption in April of $100 million and AUM is little changed in 2011 due solely to net investor flows. Performance has accounted for $1.0 billion increase in AUM in 2011.
•Investors have added a net $90 million to MNEq strategies in 2011 for a core growth rate of 0.2% which is well below the industry average of 2.3%.
Investors allocated an estimated $4.8 billion into MNEq strategies in 2010 which translates into a core growth rate of nearly 13%. This trailed only fixed income arbitrage and event driven funds among the larger strategies for the year. It is surprising that in 2011, given the economic environment, MNEq funds have not had more investor interest.
Influence of Performance on Investor Flows
HFN has completed studies of the relationship between past returns and recent investor allocations and for this report we looked more closely at these trends for MNEq strategies.
•The ten fastest growing (highest core growth rates) MNEq funds in 2011 had average returns of +13.8% in 2010. Their combined core growth rate in 2011 through April is 42%. Their average performance in 2011 is +6.2%. All of these factors are above the broad industry averages.
•The ten fastest shrinking MNEq funds in 2011 had average returns in 2010 of +2.0% and a combined core decline of 13% in 2011. Their average performance in 2011 is +0.9%. All of these factors are below the broad industry averages.
•The average 2010 performance of MNEq funds with core growth in 2011 was slightly more than double that of funds with core decline in 2011.
It is evident that prior performance played a key role in investor allocations in 2011. This is encouraging because it implies there is not a general lack of interest in market neutral strategies that resulted in the below average 2011 core growth rates, instead investors were simply less willing to allocate to under-performers in the space.
UCITS Products
There has been greater investor interest in UCITS structured MNEq funds than in non-UCITS products. Not all of the 7 MNEq UCITS products report AUM to HFN, but those that do reported above strategy and industry average growth rates, despite negative average returns in 2011. One fund in this group reported above strategy average (slightly below industry average) performance in 2011 and has also raised the most new capital of the group.
Sub-Sector Performance Breakdowns
The table to the right and the charts on the following page show recent aggregated performance for several sub-classifications and sub-styles of MNEq funds.
•Funds with a market neutral approach to sector specific equity markets have outperformed non-sector specific market neutral strategies.
•Only financial sector market neutral funds have out-performed their directional long/short counterparts in the last twelve months (LTM).
•LTM average annualized standard deviations for each market neutral sector group was a minimum of half that of their directional counterparts. In the case of energy funds, annualized volatility was 1/5th of L/S directional energy.
•Technology sector market neutral funds are the only group to outperform the HFN Aggregate Index in 2011 and also trail their directional brethren by the narrowest margin.
•Funds stating a focus on maintaining beta neutrality have outperformed those which operate a dollar neutral strategy while average returns from dedicated pairs trading funds have lagged both. However, within the pairs classification larger funds have performed relatively well.
•Though the group is small, FoFs focusing on MNEq strategies have underperformed, while those focusing on relative value strategies intended to be market neutral (credit arbitrage, event driven, etc) have performed well.
Breakdown by Region/Country Investment Market
A large amount of MNEq funds choose to focus their strategy in one particular geographical market. The table below has the relative performance across regions compared with the respective regional or country specific hedge fund benchmarks.
Market neutral equity strategies focusing on U.S. and European markets display the similar lagging return characteristics with favorable volatility, but funds focusing outside these markets have had more universally positive results.
•Funds targeting Brazilian markets have been able to produce strong returns, relative to the broad industry, over longer time frames and have outperformed the the more directional oriented HFN Brazil Index in 2011.
•Japan focused market neutral funds appeared better positioned to handle market declines resulting from the natural disaster in March and have outperformed directional Japan funds in 2011.
Going Forward
It appears that investors’ tolerance to remain invested, or allocate to underperforming market neutral equity strategies is low, but the appetite for those able to perform well is healthy. This makes the landscape slightly more difficult for market neutral equity managers because it is essentially against the strategy’s ethos to benefit from any broadly positive market movements, meaning they are less likely to benefit from forces beyond their expertise. However, to the benefit of funds that specialize on specific sectors or smaller investment regions, the trends which may separate winners from losers create more decisive trades, unlike a mega-cap environment where correlations may be greater.
Regardless, there are managers who have been efficient at generating acceptable, relatively low volatility returns across most classifications and they tend to reap the rewards in terms of allocations. However, the line appears finer between success and failure compared to directional strategies where value can be realized over longer time frames.
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