Gulf Narrows between Best and Worst Hedge Funds in 2014

The gap between the best and worst performing hedge funds has narrowed during the first half of 2014, BlackRock’s latest analysis of the hedge fund industry has found.

Hedge fund managers’ performance varied widely in 2013, but 2014 has seen the spread narrow between the top and bottom managers. Top decile hedge funds returned 11%, compared to losses of -5% for bottom decile hedge funds, narrowing the range from the previous year. In 2013, the inter-decile range was between 15.5% to -6.5%. Alpha, or the component of these returns attributable to manager skill, varied significantly between strategies, in some cases, representing almost 60% of average total returns.

David Barenborg, head of hedge fund manager research at BlackRock Alternative Advisors, said, “The total return profile across hedge fund strategies is different from this time last year, but the data confirms the key issue for investors in hedge funds remains identifying managers with the most skill.”

M&A boon for some

Funds that were able to profit from idiosyncratic risk drivers, rather than market beta, performed well in the first half of 2014, with ‘relative value’ and ‘event-driven’ managers demonstrating the highest alpha on average across hedge fund strategies.

Event-driven hedge funds, which aim to exploit pricing inefficiencies around corporate events, took advantage of the highest level of global M&A activity since 2007 to deliver an average alpha of 2.5% on total index returns of 4.3%, meaning over half of the fund’s returns were attributable to manager skill.

Barenborg added, “The M&A environment has proven to be fertile hunting ground for event-driven hedge funds, and many managers have delivered on their alpha promise. Similarly, we have also seen strategies focused on distressed investing benefit from pockets of distress in some emerging markets, as well as an increase in high yield and leverage loan defaults in the second quarter.”

Challenging market for equity hedge funds

In contrast, 2014 has so far proven a more challenging environment for alpha generation among equity hedge managers, which aim to profit from long and short positions in stock markets.

While average total returns here delivered 2.6% in the first six months, average alpha was negative at -0.8%, and this style also demonstrated a wide dispersion between the best and worst managers, BlackRock’s research found. The best equity hedge managers (top decile) have continued to deliver both high alpha and total returns of 7.6% and 12% respectively.

“Many average and below-average equity hedge funds performed well on a total returns basis in 2013, but in many cases, this was driven by the beta in their portfolios, rather than manager skill, or alpha. This has been made more evident in the less bullish equity environment we have seen this year,” Barenborg said.

BlackRock’s research and outlook

BlackRock’s research examined the H1 2014 returns of 1,549 hedge fund managers in the Hedge Fund Research, Inc database, separating returns into three categories – ‘traditional beta’ such as general market returns, ‘non-traditional beta’ such as equity sector spreads, and ‘alpha’ – the component of the returns that was unexplained and therefore attributable to manager skill.

Barenborg stated, “This research demonstrates the importance of thoughtful manager selection within any given strategy. Looking ahead, continued policy uncertainty, volatility and potential market mispricings will continue to provide opportunities for event-driven and relative value hedge funds in particular. That said, over the long-term a diversified exposure to multiple hedge fund strategies, with a selection model which focuses on each manager’s ability to generate alpha consistently rather than short-term historical total returns, will provide the best outcomes for investors.”

BlackRock manages $34.3 billion in 30 single strategy, multi-strategy and hedge fund solutions, and the firm is a pre-eminent provider of alternative investment solutions globally, with over $115 billion in assets as of June 2014.