Equity long/short inflows positive despite tough year for industry

Investor interest in hedge fund equity strategies last year declined from 2014, which was a general trend across the industry as overall asset growth ended the year nearly 50% below 2015 levels. Having said that, consistently positive inflows have been difficult for the universe to come by since the financial crisis, so a second consecutive year of positive investor sentiment could be considered a small win.

As of December 2015 and across all equity strategies, total assets under management (AUM) stood at $1.034 trillion, with $696.19 billion in equity long/short funds and $52.8 billion in market-neutral equity funds. Net investor flows for the year across all equity strategies totaled $13.67 billion; equity long/short gained $6.24 billion and market-neutral equity – a subset of non-directional equity – added $530 million. The all equity and equity long/short groups saw the bulk of assets arrive in Q2 2015: $17.2 billion and $11.41 billion respectively.

In the last four months of 2015, accelerating in December as has been the seasonal trend across the entire hedge fund industry, investor flows turned negative. All equity strategies lost $4.10 billion in that period, however flows for long/short and market-neutral strategies were slightly positive and slightly negative, respectively. Redemptions were concentrated in equity-focused event-driven strategies and seasonal redemptions from certain large non-directional quantitative equity products.

Performance gains augmented all equity strategies' AUM by $16.42 billion and equity long/short AUM by $13.31 billion in 2015 while poor performance detracted $830 million from market-neutral equity funds during the same timeframe. AUM was most impacted by performance results in August to the downside, and October to the upside. In August, the MSCI ACWI declined -6.51%.

To understand what has been driving returns within the long/short equity space, we created an asset-weighted portfolio of the 10 largest long/short equity hedge funds – a combined $71.11 billion – in the eVestment Global Database and run the portfolio through our RiskPlus simulation software. RiskPlus uses Monte Carlo simulation to regress the portfolio's return streams against a global factor model.

Figure 5 breaks down this equity portfolios exposure to specific market factors in the regression model and the factors' contribution to overall volatility.

A portfolio of these 10 hedge funds would create for an investor a more bullish position on developed Europe, Australasia, and Far East equities markets compared with US equities, while also exhibiting a long exposure to convertible bonds of companies representative of the market structure of countries in Asia-Pacific, based on positive exposures to the MSCI EAFE (+28.87%), Russell 3000 (+13.16%), and Asian Convertibles (+22.62%) factors.

In terms of market cap focus, the portfolio favors US small cap and growth stocks based on positive exposure to the MSCI Small Minus Large US USD and negative exposure to MSCI Value Minus Growth US USD factor values. A positive exposure value in size and/or style indicates a heavier weighted exposure to the first variable; with the reading reversed for a negative value.

Within the parameters of our factor model, 92.23% of the overall portfolio volatility can be explained by systematic risk. Equity and equity-related fixed income factors are the largest contributors to risk, with percentage contribution to risk of +66.57% and +22.33%. Aggregate exposures to commodities and volatility are negative, indicating exposure to these market factors reduce the portfolio's volatility.

Current exposure is generally insignificant, however it is worth noting that the yen is the largest source of expected volatility from the portfolio.

The portfolio is expected to lose money if any eight of the 11 historical crises shown in figure 6 were to occur in the coming month. A repeat of the 2008 September-October crash may be most damaging, based on a -16.95% expected portfolio return in the following month, however this is still far below long-only equity market performance during this timeframe.

A repeat of the market conditions present during the 1997 Asian crisis, or the 1998 Russian crisis would result in relatively small losses, an indication of the generally low exposure to emerging markets from the universe.