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1998 WRAP-UP: HEDGE FUND INVESTORS LAG S&P 500 BY THE LARGEST MARGIN IN THE DECADE
 

By Antoine Bernheim, Publisher. This article appeared in the February 1999 issue of Hedge Fund News┐.

1998 was a strange and disappointing experience for hedge fund investors leading many to wonder whether hedge funds are worth investing in. After surviving the third quarter with somewhat smaller losses than the 10% decline of the S&P 500, investors lagged badly during the powerful fourth quarter rally. As a result, they ended the year with the largest relative underperformance in recent memory. The U.S. stock market, led by a relatively small group of stocks, produced a very unusual set of statistics: the NASDAQ 100 Index which tracks Nasdaq's biggest non-financial stocks was up 85% while the Russell 2000 was down 3%. The S&P 500 was up 28% but more than 40% of the stocks that comprise it actually declined for the year. In addition to this narrow, technology-dominated market, volatility achieved levels only seen twice since the early 30s: 1987 and 1973. Russia's unexpected default on its local currency debt market produced an earthquake in the credit markets. Major currencies also showed unusual behavior: after the U.S. government tried unsuccessfully in June to stop the advance of the dollar against the yen, the dollar proceeded to drop precipitously by 23% between August 11th and December 31st. Deflationary concerns dominated the commodities markets, with oil dropping to 25 year lows in real terms.

1998 results of the 50 largest hedge funds

1998 Net Return after all Fees

Number of Hedge Funds┐

Capital @1/1/99 in
$ million

Capital @ 1/1/98 in
$ million

> 40%

6

12,198

7,781

25% to 40%

4

7,807

5,544

15% to 25%

9

17,938

13,045

0% to 15%

13

26,616

25,896

0% to -15%

5

20,327

22,065

-15% to -25%

4

5,863

7,094

<-25%

9

10,176

17,364

Total

50

100,925

98,789


In this confounding period, hedge funds disappointed their investors with volatile results and some outright disasters. Just a handful emerged from this turmoil with an unblemished risk/return profile. Our annual confidential survey of what we believe to be the 50 largest hedge fund groups reflects the character of the year, with an unusual number of funds encountering losses in excess of 25%. All those included in the survey had capital under management in excess of $1 billion at one point or another during 1998. Total assets were basically flat, around $100 billion, between the beginning of 1998 and the beginning of 1999.

THE TOP 50 MEDIAN STATISTICS

Median Equity

Median Return

S&P 500

1998

$1.39B

9.5%

28.6%

1997

$1.27B

20%

33.4%

1996

$0.60B

21%

22.9%


The unusual distribution of returns caused the capital weighted return to be close to zero, well under the median figure of 9.5% contrary to 1997 when the capital weighted return was over 8 percentage points above the median. The sample includes six substitutions from last year's survey.

The bear market of the third quarter in equities, the flight to quality in the credit market that ensued and the poor performance of emerging markets explain the exceptional losses incurred among certain large hedge funds. After the selling climax of August 31st, a number of funds found themselves having given back their year to date profits, or worse. Few were daring enough to take a bold position on the market recovery following worldwide interest rate cuts. Other funds lost capital beyond any possible short-term recovery.

In terms of capital flow activity, we estimate that 28 hedge fund groups out of 50 raised net capital of $7.8 billion during the course of 1998, while capital at 21 hedge fund groups was reduced by a total of $8.1 billion in net redemptions, of which $2 billion was returned voluntarily by managers. Capital flows were volatile during the year, as was performance. Our survey also indicates that six hedge fund groups raised net capital between $500 million and $1 billion, not including a couple of funds which started up during the year with initial capital between $500 million and $1 billion. Six funds had net redemptions between $500 million and $1 billion. Overall, redemptions did not reach the levels feared after the summer when the financial world may have seemed to be coming to an end. Nevertheless, there were significant net withdrawals by banks, European investors and Japanese institutions.

In some ways, 1998 marked an important turn on several fronts. First, investors are reviewing their return and risk objectives with respect to their hedge fund portfolios which have shown to be a disappointing alternative to a big cap-led bull market in equities. Secondly, there are questions regarding the degree to which large funds are able to control their risk better than smaller funds. Institutional investors which need to make significant capital allocations had become increasingly comfortable with large hedge funds. For those, asset size was a contributing factor to performance because it enabled them to attract the diversity of talent necessary to capture opportunities on a global basis. Some of the significant investment themes that they were able to capitalize on without specializing into, such as icing their portfolios with emerging markets investments or leveraging the positive yield differential between the yen and the dollar, hurt them badly in 1998. Thirdly, leverage is obviously a concern for certain strategies, not only because it magnifies gains and losses but also because the broker/dealer-financing used by hedge funds may be withdrawn overnight, generally at the worst possible time. It is probably necessary for stock market returns in the US and Europe to revert to the mean in order to validate hedge fund portfolio constructions. After all, 1998 was the first time in history that the Dow Jones posted four consecutive years with double digit gains. The odds favor better prospects for the hedge fund community.u

 
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