Drivers of Change in the Hedge Fund Industry: Performance

View the full edition of Spotlight at: https://www.preqin.com/docs/newsletters/hf/Preqin-Hedge-Fund-Spotlight-August-2016.pdf

 Drivers of Change in the Hedge Fund Industry: Feature Article Download Data Performance

With recent returns lower than investors have come to expect, the performance of the hedge fund industry is under increasing scrutiny. Joe McGee takes a closer look at the performance of the asset class and its implications, using data from the 2016 Preqin Alternative Assets Performance Monitor and upcoming Preqin Investor Outlook: Alternative Assets, H2 2016.

In Brief:

► With 79% of investors reporting ► Total industry returns have fallen ► Due to the proliferation of funds that their hedge fund investments short of investor expectations; in recent years and the wide have fallen short of expectations however, as the Preqin All- dispersion between the top over the past 12 months, both Strategies Hedge Fund benchmark performing strategies and individual fund managers and investors have encompasses a range of vehicles managers in the industry today, identifi ed performance as a key investing across different strategies, investors are fi nding it more diffi cult issue in the hedge fund industry there are some funds – particularly to pinpoint the most attractive today. CTAs – that are meeting investor investment opportunities in the requirements. current environment.

Following returns of 1.97% in 2015, Fig. 1: Investor Views on Whether Their Hedge Fund Investments Have Lived the Preqin All-Strategies Hedge Fund up to Expectations over the Past 12 Months, December 2013 - June 2016 benchmark returned 1.09% in the ﬁ rst six months of 2016. With industry 100% returns considerably below the double- 8% 9% 6% 90% 21% digit ﬁ gures experienced in 2009, 2010, 15% 2012 and 2013, investors have become 80% increasingly concerned about the impact Exceeded of hedge fund performance on their 70% Expectations portfolios: 79% of investors surveyed for 57% 58% the upcoming Preqin Investor Outlook: 60% Met Expectations Alternative Assets, H2 2016 felt that their 50% hedge fund investments had fallen short 63% of expectations over the past 12 months, 40% 79% up from 33% in December 2015 (Fig. 1.). 30% Fallen Short of Expectations Using data from the recently launched Proportion of Respondents 20% 35% 2016 Preqin Alternative Assets 33% Performance Monitor and forthcoming 10% 16% Preqin Investor Outlook: Alternative 0% Assets, H2 2016, we look at how different Dec-13 Dec-14 Dec-15 Jun-16 strategies have performed, investor Source: Forthcoming Preqin Investor Outlook: Alternative Assets, H2 2016 Fig. 2: Hedge Fund Performance by Strategy (As at June 2016)*

H1 2016 H2 2015 12 Months 3-Year Annualized 3-Year Volatility Macro Strategies Relative Value Strategies Macro Strategies Relative Value Strategies Relative Value Strategies 3.26% 1.06% 3.14% 5.22% 1.84%

CTAs Macro Strategies CTAs CTAs Credit Strategies 3.18% -0.08% 2.49% 5.10% 2.35%

Credit Strategies CTAs Relative Value Strategies Multi-Strategy Macro Strategies 2.54% -0.57% 1.82% 4.82% 2.35% Event Driven Strategies Credit Strategies Credit Strategies Credit Strategies Multi-Strategy 1.63% -0.83% 1.72% 4.81% 3.18% Multi-Strategy Multi-Strategy Multi-Strategy Equity Strategies CTAs 1.53% -0.97% 0.54% 4.79% 4.79% Relative Value Strategies Event Driven Strategies Event Driven Strategies Event Driven Strategies Event Driven Strategies 0.59% -3.99% -2.32% 3.61% 5.04% Equity Strategies Equity Strategies Equity Strategies Macro Strategies Equity Strategies 0.10% -4.35% -4.31% 3.25% 6.17%

Source: 2016 Preqin Alternative Assets Performance Monitor

*Please note, all performance information includes preliminary data for June 2016 based upon returns reported to Preqin in early July 2016. Although stated trends and comparisons are not expected to alter signiﬁ cantly, ﬁ nal benchmark values are subject to change.

 Drivers of Change in the Hedge Fund Industry: Feature Article Download Data Performance

views on hedge fund performance and Fig. 3: Performance of Hedge Fund Sub-Strategies, July 2015 - June 2016 the role that the asset class can play in investor portfolios. CTA - Counter-Trend 7.11% Asset-Backed Lending 6.36% CTA - Pattern Recognition 6.29% Relative Value Arbitrage 6.13% Behind the Headline Numbers Insurance-Linked Strategies 5.86% Risk/Merger Arbitrage 5.32% Macro 3.98% Volatility 3.83% Behind the industry benchmark, there CTA - Macro 3.70% are a wide range of vehicles investing Fixed Income 3.31% CTA - Trend-Following 3.29% in different instruments, strategies and Statistical Arbitrage 2.30% Commodities 1.74% regions – some of which have performed CTA - Option Writing 1.65% Foreign Exchange 1.40% better than others in the current economic Equity Market Neutral 1.04% Mortgage-Backed Strategies 0.91% environment (Fig. 2). Among top-level CTA - Arbitrage 0.40% Fixed Income Arbitrage 0.38% strategies, macro strategies were the Special Situations -0.53% Long/Short Credit -0.66% top performing over the past 12 months Event Driven -2.50% Long/Short Equity -3.86% (+3.14%), followed by CTAs (+2.49%). Convertible Arbitrage -4.11% Relative value strategies were the Value-Oriented -4.68% Activist -5.57% highest returning strategy over a three- Long Bias -6.14% Distressed -11.01% -7.41% year period (+5.22% annualized) with the Sector-Focused lowest three-year volatility (1.84%). -12% -8% -4% 0% 4% 8%

Equity strategies, on the other hand, have Net Return performed worse than other strategies Source: 2016 Preqin Alternative Assets Performance Monitor over the past 12 months, particularly in the second half of 2015 (-4.35%), when that continuing uncertainty about China class, they recognized that some funds the volatility in Chinese fi nancial markets had negatively impacted performance had outperformed others and expressed spread to equity markets worldwide. in the fi rst half of the year, particularly varying levels of satisfaction with Although they have better long-term for fund managers based outside North different hedge fund strategies (Fig. 5). performance (+4.79% three-year America and Europe (71%, Fig. 4). In Among the better performers relative to annualized), they also have the highest North America, crowding of trades was investors’ expectations were systematic three-year volatility (6.17%). also seen as a negative factor, with 41% CTAs: 92% of investors felt that these of respondents believing that this had met their targets. Discretionary CTAs For individual sub-strategies, there negatively affected their funds. and credit strategies also performed is a large difference between the top comparatively well, meeting the performing sub-strategy (CTA – Counter- On the positive side, signifi cant expectations of 63% and 50% of Trend, +7.11%) and the worst performing proportions of North America- and investors respectively. At the other end of (Sector-Focused, -11.01%, Fig. 3). Europe-based fund managers felt that the scale, no investors surveyed felt that Other top performing sub-strategies they had benefi ted from changes in their activist investments had met their include asset-backed lending (+6.36%), oil and commodity prices in the fi rst expectations – a sign of a diffi cult H1 pattern recognition CTAs (+6.29%) and half of the year. Fund managers based 2016 for activist funds marked by, among relative value arbitrage (+6.13%), while elsewhere felt that interest rate policy in other things, the continued share price distressed and long bias funds also Europe, Japan and the US had benefi ted decline of Valeant Pharmaceuticals, a had a diffi cult year (-7.41% and -6.14% their funds. former activist favourite. respectively). Investor Satisfaction with While many investors feel that some Factors Affecting Performance Performance hedge fund strategies have been meeting their targets, a signifi cant proportion When asked about the major events Although investors surveyed by Preqin remain concerned that their overall affecting performance in H1 2016, a reported a general dissatisfaction with portfolio of hedge funds has not been large proportion of fund managers felt the recent performance of the asset living up to expectations recently: 41%

Fig. 4: Fund Manager Views* on the Most Significant Positive and Negative Events for Hedge Fund Performance by Fund Manager Location

North North Asia & Rest Europe Asia & Rest of World Europe America America of World

Oil Price Oil Price Zero and Negative US Interest Zero and Negative Commodity Volatility Volatility Interest Rate Policy in Rate Policy Interest Rate Policy Price Volatility Europe and Japan in Europe and Japan 43% 48% 53% 31% 34% 38%

Commodity Continuing Commodity Continuing China Oil Price Price US Interest Rate Policy China Price Volatility Uncertainty Volatility Volatility Uncertainty 52%  43% 37% 46% 37%  35% Continuing US Interest US Interest Commodity Price Crowding of US Interest Rate China Rate Policy Rate Policy Volatility Trades Policy Uncertainty 36% 35% 32% 41% 37% 71%

Source: Preqin Hedge Fund Manager Outlook, July 2016 *Percentages refer to proportion of total number of respondents from each region that consider the event to have affected performance positively or negatively. 3 Hedge Fund Spotlight / August 2016 © 2016 Preqin Ltd. / www.preqin.com View the full edition of Spotlight at: https://www.preqin.com/docs/newsletters/hf/Preqin-Hedge-Fund-Spotlight-August-2016.pdf

 Drivers of Change in the Hedge Fund Industry: Feature Article Download Data Performance

of investors surveyed by Preqin reported Fig. 5: Hedge Fund Portfolio Performance in H1 2016 Relative to Expectations that they have reduced confi dence in the of Institutional Investors by Strategy ability of hedge funds to achieve portfolio objectives over the past 12 months, 100% 0% 12% compared with only 12% that reported 90% increased confi dence (Fig. 6). 32% 80% 41% 39% 50% 47% 44% 70% 63% A key diffi culty for investors is fund Met Expectations manager selection: even within 60% 92% strategies, returns vary considerably 50% 100% 88% between different funds. As shown in Fig. 40% 68% Fallen Short of 7, the interquartile range for the returns of 30% 59% 61% equity strategies funds over the previous 50% 53% 56% Expectations 20% 12 months is over 15 percentage points, 38%

Proportion of Respondents 10% while credit strategies have the least 8% variation, at 6.8 percentage points. With 0% more than 15,900 active hedge funds open to investment today, investors are CTAs Activists Equity Credit ﬁ nding it harder to identify the better Macro CTAs Strategies Strategies Strategies Systematic Funds of

performing funds. Forty-six percent of Strategies Strategies Event Driven Discretionary Multi-Strategy Hedge Funds

investors surveyed by Preqin for the Relative Value upcoming Preqin Investor Outlook: Alternative Assets, H2 2016 stated that Source: Forthcoming Preqin Investor Outlook: Alternative Assets, H2 2016 it is currently more difﬁ cult to source attractive investment opportunities than Fig. 6: Investors’ Change in Confidence in Hedge Funds’ Ability to Achieve 12 months ago, compared with only 6% Portfolio Objectives over the Past 12 Months that are ﬁ nding it easier.

The Role of Hedge Funds in Investor Portfolios 12% Nevertheless, despite investor concerns about short-term performance, returns Increased Confidence in over the longer term have been more Hedge Funds promising, with ﬁ ve-year annualized 41% returns of 5.26% for hedge funds and No Change 4.53% for CTAs. Such returns are often compared unfavourably with equity indices such as the S&P 500 Index, Reduced Confidence in but these comparisons are not always Hedge Funds justiﬁ ed. Investors surveyed by Preqin 47% have previously indicated that they value hedge funds less because of the possibility of high absolute returns than because of the role that they can play in helping to diversify investors’ portfolios, as well as providing low correlation Source: Forthcoming Preqin Investor Outlook: Alternative Assets, H2 2016 to other asset classes and reducing portfolio volatility. Fig. 7: Interquartile Range of Hedge Fund Returns by Strategy, July 2015 - June 2016 The 2008 Global Financial Crisis (GFC) highlighted the extent to which many 10% institutional investors needed to diversify into alternatives such as hedge funds, 5% as the traditional “60/40” portfolios of equities and bonds failed to protect assets during the crash. Hedge funds fell 0% only -17.35% overall in 2008, compared with -38.49% for the S&P 500 Index, -5% with certain strategies such as macro strategies performing better (+4.35%). In the aftermath of the GFC, an increasing 12-Month Net Return -10% number of institutions turned to hedge funds to help meet long-term liabilities -15% while reducing risk within their portfolios. CTAs The GFC has been followed by a Equity Credit Macro Strategies prolonged bull run in equity markets and Strategies Strategies Strategies Strategies there are signs that some investors may Event Driven Multi-Strategy be losing patience with hedge funds as Relative Value Source: Preqin Hedge Fund Online

 Drivers of Change in the Hedge Fund Industry: Feature Article Download Data Performance

they are not adding the high returns of Fig. 8: Rolling Capture Ratios of Hedge Funds Relative to the S&P 500 Index, traditional equity markets. However, with June 2014 - June 2016 continuing uncertainty about the health of the global economy and the risks 100% posed to ﬁ nancial markets by geopolitical 90% events, recent outﬂ ows of capital from the asset class may be reversed if hedge 80% funds can once again prove their value in 70% 64% helping investors meet long-term return 60% goals, with less volatility and risk than investing through equities. As shown in 50% Fig. 8, hedge funds have consistently 40% captured more of the upside of the S&P 30% 500 Index than they have the downside 27% 20%

in recent years, with a three-year upside Capture Ratio Three-Year capture ratio of 64% in June 2016, 10% compared with a 27% downside capture 0% ratio. As a result, hedge funds have tended to experience smaller drawdowns Jul-15 Jul-14 Jun-16 Jun-15 Jun-14 Apr-16 Apr-15 Jan-16 Jan-15 Feb-16 Feb-15 Sep-15 Sep-14 Oct-15 Oct-14 Mar-16 Mar-15 Nov-15 Nov-14 Aug-15 Aug-14 Dec-15 Dec-14 May-16 than the S&P 500 over the past six years May-15 (Fig. 9). Upside Capture Ratio Downside Capture Ratio

Outlook Source: 2016 Preqin Alternative Assets Performance Monitor

Both fund managers and investors and conditions had shifted in favour surveyed by Preqin believe that of investors over the past 12 months, Data Source: performance is one of the key factors compared with only 8% that felt that they driving change in the hedge fund industry changed in favour of fund managers. (see Preqin Special Report: Hedge Fund Preqin’s Hedge Fund Online Manager Outlook and the upcoming In order to address investors’ concerns features detailed profi les for more Preqin Investor Outlook: Alternative and ensure continued allocations to than 15,900 hedge funds open to Assets, H2 2016 for more information). hedge funds, fund managers will need investment worldwide, offering a The disappointment of a large proportion to take measures to reassure investors complete overview of the industry. (79%) of investors with the returns of about their funds and educate them about Use Hedge Fund Online to: hedge funds over the past 12 months is the potential benefi ts of the asset class leading to reduced confi dence in these (Fig. 10). Fund managers are seeking • Access detailed profi les of funds ability to meet portfolio goals, to do so by improving transparency each individual fund and its which in turn has led to outfl ows of capital on their strategy, risks and business, manager from hedge funds in recent quarters (see investing in their middle- and back-offi ce • Analyze top performing funds page 7). infrastructure and leading educational by core strategy initiatives to improve knowledge about • View information on key Industry performance has brought to the industry among CIOs and the wider contacts at each top the fore the issue of fees and the extent investing public. Their ability to do so performing fund and more. to which fund manager and investor as well as continue to generate better interests are properly aligned and returns throughout the rest of 2016 (see For more information, please visit: shifted the balance of negotiations in page 11), will be key requirements for the favour of investors. Fifty-nine percent hedge fund industry to continue to grow www.preqin.com/hedge of respondents felt that fund terms in the future.

Fig. 9: Drawdowns of Hedge Funds, January 2010 - Fig. 10: Fund Manager Strategies to Overcome Investors’ June 2016 Concerns about Hedge Funds

80% 69% 70% 63% Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14 Oct-14 Jan-15 Apr-15 Jul-15 Oct-15 Jan-16 Apr-16 58% 0% 60% -2% 50% 42% 40% -4% 33% 31% 30% -6% 20% 16% -8% 11% 11% 10% 10% 8% 7% -10%

Proportion of Respondents 0% -12%

Drawdown Size -14% -16% -18% Infrastructure Strategy

Equity Strategies Event Driven Strategies Host Training and Institutional Quality of Trustees Educational Events Investment Team Investment Multi-Strategy Macro Strategies Industry Events Active in Social Media Investment Team Investment Member of Industry Credit Strategies Relative Value Strategies Merits of HF Investment Produce White Papers on Educate on HF Industry to Transparent about Risks of Transparent about Strategy Offices Open to Client Visits Provide Education to Board Educate on Firm Strategy to Educate on Firm Present at Conferences and

CTAs S&P 500 Association and Promote HFs

Source: 2016 Preqin Alternative Assets Performance Monitor Source: Preqin Hedge Fund Manager Outlook, July 2016

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