Emerging market equities suffered most in 2008, says Morningstar

Date: Friday, January 23, 2009
Author: Morningstar.com

The Morningstar 1000 Hedge Fund Index lost 10.3 per cent in the fourth quarter of 2008 and 22.2 per cent for the year, wiping out the last two years of gains. The index bounced back slightly after extreme market illiquidity and volatility in January and March, but since May, hedge funds have been on a steady decline.

Massive losses in September and October of 7.9 per cent and 9.8 per cent, respectively, quashed any hope of salvaging the year, although it ended on a positive note with a 2.1 per cent gain in December.

The Morningstar/MSCI Asset Weighted Hedge Fund Composite index, which hedges US dollar exposure, lost 12.9 per cent in 2008, while the equally weighted version lost 16.4 per cent, reflecting the poorer performance of smaller funds.

Investors lost their appetite for hedge funds in 2008, as vehicles intended to deliver absolute returns were forced to resort to relative claims of success, Morningstar says. Since the beginning of the credit crunch in August 2007, hedge funds have effectively acted as muted versions of equities, providing positive returns only twice when the MSCI World Stock Index was negative. Still, the Morningstar 1000 Hedge Fund Index did outperform the MSCI World Index by a sizeable 20 percentage points for 2008.

'In 2008, hedge fund managers generally failed to deliver,' says Morningstar hedge fund analyst Nadia Papagiannis. 'The average hedge fund may have lost less than the stock market, thanks in part to large cash allocations, but this level of performance was not why investors agreed to pay 2 per cent management fees and 20 per cent performance fees.'

Investors redeemed assets aggressively in 2008. Hedge fund inflows peaked in June 2007 and bottomed in October 2008, when more than USD21bn left the industry. In November, another USD19.4bn flowed out of hedge funds, bringing outflows for the first 11 months of the year to more than USD44bn.

Hedge fund investors showed a strong tendency toward performance chasing, investing more after positive months and withdrawing assets after down months. Investors following this strategy ended up losing less than the index, as the markets trended increasingly downward as the year progressed.

High redemptions and little possibility of collecting performance fees in the near future led to the closure of record number of hedge funds in 2008. The number of funds dropping out of Morningstar's database increased by more than 150 per cent, with 1,158 single-manager funds and 490 funds of funds removed in 2008 compared to 434 single-manager funds and 208 funds of funds the previous year. Funds are removed from the database if the fund liquidates, if the manager wishes to stop reporting returns, or if funds fail to report returns for six months.

Emerging market equities proved to be the worst strategy in 2008. Effectively a market-return strategy, these funds are only able to invest in stocks or hold cash, as shorting emerging markets holdings is very difficult. Emerging stock markets performed worse than other markets, as skittish investors pulled capital out of risky assets.

Although emerging markets bounced back in December, the MSCI Emerging Markets Index lost almost 55 per cent in 2008 while the Morningstar Emerging Market Equity Hedge Fund Index lost 45.6 per cent in 2008 and 20.7 per cent in the last quarter alone.

The ability to hedge helped the Morningstar/MSCI Developed Markets Hedge Fund Index, which lost only 11.9 per cent last year. Of developed market equities funds, Europe equity hedge funds fared the best on a relative basis, with the Morningstar Europe Equity Hedge Fund Index beating the MSCI Europe stock index by about 30 percentage points.

The Asian Equity Hedge Fund Index also outperformed the MSCI AC Asia Index by more than 19 percentage points. Late in the year, European and Asian hedge funds got some relief, as governments announced rate cuts and stimulus packages, boosting the equity markets.

The best-performing strategy this year was global trend following, a systematic strategy that tracks price trends in liquid derivatives such as futures, options and currency forwards. The Morningstar Global Trend Hedge Fund Index gained 7.4 per cent in the fourth quarter of 2008 and 9.8 per cent for the year overall.

In the first half of the year, these funds profited from an upward trend in commodities and a downward trend in the US dollar, as uncertainty over the US economy led to increased investment in 'hard' assets. The third quarter saw a sharp reversal in these trends, catching global trend funds by surprise. But these funds recovered in the fourth quarter, as the drop in oil and the rise of the dollar was sustained.

Global non-trend following funds, which trade the same instruments as global trend funds but in a more discretionary manner, gained 0.9 per cent in the fourth quarter, ending the year down 1.2 per cent, less than every other losing category. These funds benefited from the liquidity of the instruments that they trade, enabling them to get in and out of the market quickly.

Convertible arbitrage funds took a big hit in 2008. The Morningstar Convertible Arbitrage Hedge Fund Index dropped 13.1 per cent over the quarter and 24.9 per cent over the year. In May, convertible bond issuance hit an all-time high as financial firms desperately sought capital. But in September, when the financial firms' stocks suffered major damage, the Securities and Exchange Commission and Financial Services Authority banned the ability to short them.

This caused convertible arbitrage funds, which typically take long positions in convertible bonds hedged with short positions in the related stock, to plunge into the abyss. As convertible bonds continued to be viewed as risky assets, and as yields on risky debt rose sharply, these leveraged funds were subjected to margin calls and forced selling.

Plagued by a similar fate, funds in the Morningstar Debt Arbitrage and Morningstar Global Debt Hedge Fund Indexes plunged 8.2 per cent and 18.7 per cent respectively in the last three months of the year, and by 16.7 per cent and 28.5 per cent over the year as a whole, as investors fleeing to Treasuries caused credit spreads to widen to near-Depression-era levels in even investment-grade corporate bonds.

Defaults on high-yield bonds rose to a record high in November, squeezing the price of high-yield securities and sending the Morningstar Distressed Securities Hedge Fund Index down 16.1 per cent for the fourth quarter, and 25.3 per cent for the year. Hedge funds buying distressed assets early in the credit crunch saw their investments deteriorate even further alongside the economy.

Poor timing and illiquidity also took a toll on corporate actions funds. The Morningstar Corporate Actions Hedge Fund Index dropped 28.9 per cent in 2008, including 13.2 per cent for the final quarter. These value-seeking funds look for events such as privatisations, mergers and acquisitions, share repurchases, IPOs and spin-offs to enhance share value, but such events proved scarce during the steep bear market.

Tight credit, badly performing equity, and lack of institutional-investor demand turned the leveraged buyout boom, which peaked in mid-2007, to bust last year, which also saw the collapse of a record number of merger and acquisition deals and a 50 per cent drop in IPO activity. 'The easy credit bubble burst, and along with it a great many hedge funds,' Papagiannis says.