By Richard Wilson

Investors have cast a wary eye on the performance of hedge funds so far during 2007. While the final data for all of 2007 is still a few weeks away, we decided to take a look at how various hedge funds have performed through most of the year and compare them with other investment benchmarks. We will update this data for you early in 2008.

In addition, we wanted to highlight those funds that have performed relatively well and those that have lagged somewhat. We've also provided some analysis behind the performance of several popular strategies.

Hedge Fund Data (Source: HFR, Inc.)

Performance Review

The average hedge fund included in the HFR Fund Weighted Composite index posted a moderate Q3 gain of 1.36%. This was largely due to a down month in August (-1.48%) followed by a recovery in September (2.82%) before quarter end. The first three quarters of 2007 have been a mixed bag for hedge fund performance in relation to the S&P 500. The S&P 500 returns of 10.86 beat nearly half of all hedge fund indexes.

One important point to keep in mind is that 10.86% is an above-average return for the S&P 500. What's more, many hedge funds are designed so that they do not move with the markets or the S&P 500 in this case, so it is not necessarily a bad sign that each index did not beat the benchmark. High tides typically raise all boats in the sea. Hedge funds are relied upon for unique return stream diversification, and it would be far more worrisome if hedge funds were consistently performing in line with the S&P 500 on a frequent basis.

Q3 Winners:

• Short selling strategies as a whole came out strong through the volatility this fall with average performance of 6.16% (although still down 2.01% YTD through 11/1/07)

• Emerging Market funds gained 4.7% in Q3 (and are up 26.64% YTD through 11/1/07)

Q3 Losers:

• Distressed Securities funds dropped an average 1.63%

• Event Driven funds dropped an average .83%

• Fixed Income High Yield funds dropped 4.14%

Hedge Fund Strategy Trends & Insights

• Large Cap equities are starting to come into favor because of their multinational operations that diversify economic risk, their exports which take advantage of the dollar and their reputation as being a safe harbor for earnings growth during choppy times in the market. Hedge funds running long-only or long/short portfolios will probably be overweighting this area and funds whose expertise is really in GARP or moves made on technical indicators might come out on top for Q4 and Q1 of 2008.

• In Q3 Emerging Market funds attracted just 3.64% of new capital. This was due to two factors. First China is becoming almost too popular for its own good with some questioning whether current mid and large cap PE ratios are too high. Some are worried of a sharp correction at some point over the next two or three quarters. Second, the U.S. markets have seen volatility and unsteady footing through the end of Q2 and Q3 making investors look for solid ground on which to place investments.

• While almost unheard of three years ago, Litigating Funding is becoming an increasing popular hedge fund strategy with returns that are driven by team expertise and returns which have a low correlation to the markets. We will probably see a few funds focused just in this area start up in early to mid 2008.

• While Fixed Income High Yield strategies performed the worst during this last quarter, it also had the highest percentage rise in new assets, gaining $2.2B in new money in Q3 compared to $178m in Q2. This may be due to institutions having a long 18-24 month holding pattern on allocation to high yield investments; many now hope to put capital to work by picking up cheap instruments before they are re-valued again on the way back up. Don't be surprised to see Q4 showing an even greater inflow of high yield investments.

• The $22.5 billion inflow of assets by Hedge Fund of Funds is the second highest ever, barely topped by a Q3 2006 inflow of $23.8B towards hedge fund strategies. This record likely will be beaten with close to $25B of net inflows in 2008 as RIA assets drive upwards and more institutions move from 6-8% to 12-20% allocations.

• The asset flows to high yield contrast sharply with what happened with short selling asset flows in Q3. While short selling funds were on average the best performing of all groups they took in less than $1M in new flows, a rounding error by most accounts.

• Two strategies which experienced net outflows during Q3 were Equity Market Neutral and Market Timing losing $278M and $39M respectively. This may be because these strategies typically have quantitative modeling intensive investment processes which sometimes have difficulty navigating the types of volatile market conditions that we have recently seen.

Asset Inflows and Outflows - The Big Picture

A recent report from the Hedge Fund Research Inc. shows that hedge funds gained $45.2B in assets during the third quarter of 2007. Event-Driven, Relative Arbitrage, and Equity Hedge strategies received the lion's share of those inflows taking in a respective $9.8B, $9.2B and $8.5B. Even though emerging markets hedge funds were once again a top performer, they gained a modest $2.7B in Q3. Regardless of strategy, roughly half of all new hedge fund assets came from Fund of Hedge Funds, bringing the total fund of fund assets to a record $773 billion.

These inflows and outflows are important for investors to track. Since hedge funds cannot advertise, a small handful of fraudulent or poor performing hedge funds in the news can often make millions of people think that the hedge fund industry is headed towards financial ruin. Looking at the overall picture in terms of performance and assets gains can give you a more realistic pulse on how the industry is really doing as a whole.

"Overall industry fund flows were positive despite performance volatility and specific instances of investor redemptions," said Kenneth J. Heinz, president of Hedge Fund Research. "Flows were strongest into Fund of Hedge Funds and Event Driven Strategies, as well as many of the larger firms in the industry, each of which suggest continued capital concentration in the industry."

Ultra-Wealthy Increasing Hedge Fund Allocations

A recent study by the Institute for Private Investors showed that the ultra-wealthy are increasingly allocating more of their portfolios to hedge funds. Ultra-wealthy investors are those who are typically defined as having over $50M in investible assets. They are sometimes also referred to as ultra high net worth individuals (uhnw).

In this most recent study, 25% of the ultra-wealthy who responded to the study said they were looking to increase their allocation to hedge funds while 11% said they were planning on decreasing their exposure to this type of investment vehicle. Another interesting trend that emerged from the survey: 63% of the respondents planned on increasing their investments outside of their own domestic markets.

The move to a larger allocation to emerging and developed markets internationally has been running parallel to hedge funds for several years now and some internationally focused hedge funds have faired quite well in terms of performance returns and asset growth from new investors.