Hedge funds had their best year since 2003 last year, thanks to strong returns during the second and third quarters.
The hedge fund industry experienced a contraction during the recent downturn, as swarms of investors demanded redemptions and many funds were forced to liquidate. But the market’s recovery in early 2009 set those funds up that did survive the crisis to gather assets en masse.
More than 20% of hedge funds shut down in the past two years, as 1,500 funds were liquidated in 2008 and 900 more in 2009, says Claude Schwab, a partner at Heidrick & Struggles International and head of its U.S. hedge fund practice. Schwab says hedge fund managers with less than $1 billion in assets under management remain “especially vulnerable.”
The Morningstar 1000 Hedge Fund Index ended the year up an impressive 19.5%, just missing 2003’s 20.3% rise, according to preliminary data from Morningstar, and the currency-hedged Morningstar MSCI Hedge Fund Index, finished the year up 14.1%. Each of the indexes benefitted from strong second and third quarters, in which the stock and bond markets saw mostly roaring returns—and investors began putting cash that had been on the sidelines back into the market. That was followed by a much quieter fourth quarter, when the Morningstar 1000 and MSCI Indexes rose only 2.1% and 1.9%, respectively, for the quarter.
In a pattern seen throughout both the mutual fund and exchange-traded fund industries, the hedge fund strategies that failed the most during the 2008 downturn prospered in 2009. The Morningstar Emerging Markets Equity Hedge Fund Index, for instance, came forging back from a 45.7% drop in 2008 to finish last year up a whopping 50.4%. The currency-hedged Morningstar MSCI Emerging Markets Hedge Fund Index rose 37.1% last year. And the Morningstar U.S. Small Cap Equity Hedge Fund Index, which dropped 32.8% in 2008, returned 36.4% last year. While these funds have not yet recovered from 2008’s losses, they are certainly headed in the right direction.
“Last year was a windfall year for hedge funds,” says Nadia Papagiannis, alternative investment strategist at Morningstar. “The hedge funds that survived 2008’s industry purge, or those that launched in the aftermath, picked up assets at rock-bottom prices and rode the recovery to near record profits, particularly in U.S. Equity and debt markets.”
Another strategy that fell victim to the 2008 downturn but took off in last year’s recovery environment was convertible arbitrage, a complex strategy often used by hedge funds which involves taking a long position on a convertible security and a short position in its converting common stock. Many convertible arbitrage hedge funds collapsed in 2008, leaving plenty of room for those remaining in the sector to take off once some liquidity returned to the market. The strategy’s benchmark hedge fund index was up 37% last year. Merger arbitrage also picked up the pieces from a disappointing 2008 to finish the year up 30.0%.
Other strategies, however, suffered in the early-recovery environment of 2009, in which the Dow Jones Industrial Average closed the year up almost 20%. These strategies included those that take bets on declining stocks—which soared during the 2008 meltdown—including the Morningstar Short Equity Hedge Fund Index and the Morningstar Global Trend Hedge Fund Index, which fell 1.4% and 1.5%, respectively, last year.