By Richard Wilson, Hedge Fund Consultant, Special Contributor to Wealth Management Exchange

Hedge Fund Performance Review: 2007 and early 2008

While there were some quantitative hedge fund casualties last year, many hedge fund managers were able to navigate the credit and equity market volatility seen in August through December and still come out of the year with strong positive performance. The hedge fund industry finished off 2007 ahead of most equity benchmarks with returns averaging 10.02% (HFRI WC Index) across the industry vs. S&P 500 performance of just 5.42% for the year.

Volatile equity markets have recently taken both long only equity and hedge fund managers for a ride, as 2008 markets have already proved to be more turbulent than any part of 2007. While many individual hedge funds are in negative performance territory, the industry as a whole beat the S&P 500 benchmark by over 5% in February. HFN reported the average hedge fund performance in February was 2.14% while the S&P 500 returned -3.25% during this same time period. The trend of increasing allocations to hedge funds is paying off for institutional investors, as the hedge fund industry as a whole continues to outperform a slew of market benchmarks. The graph below shows recent hedge fund performance returns vs. the S&P 500 returns.

2007 & Q1 2008 Winners:

• Option strategies are performing relatively well so far in 2008. In January this sector returned -.04% outperforming most diversified traditional equity portfolios.

• Global Macro hedge funds are also limiting their investor's losses with average performance in January of -.79%.

• Commodity hedge funds especially those long on heavy metals are fairing well in 2008 as they have seen a boom as equity markets become less stable.

• Phil Goldstein and his Bulldog hedge fund are winners for his once again heroic efforts fighting the extreme SEC regulations on hedge fund advertising. He single-handedly stood up for the hedge fund industry to fight the hedge fund registration requirement that the SEC proposed a few years ago. Ironically, even if he fails against the SEC he has gained more national recognition than he could hope for through traditional advertising.

2007 & Q1 2008 Losers:

• Finance Sector hedge funds are down 6.23% over the last 12 months ending January 2008. HFN reports that this is one of only two hedge fund benchmarks with negative returns during this period of time.

• Energy hedge funds are struggling. Many of them are performing in negative territory so far for 2008 and they started out in January with the worst performance during that month since 1998.

• Hedge funds out of India are struggling with average performance of -15.40% YTD after losing an average 3.92% in February.

• The long only equities hedge fund niche. With an increasingly scrutinized fee levels those hedge fund managers who invest heavily in equities, do not short stocks or use other instruments yet still charge 2 and 20% are seeing additional push back from investors. The momentum of 130/30 funds and their typical 1.25/10 or 1.25/20 structures is going to continue to apply downward pressure on this niche.

Hedge Fund Strategy Trends & Insights

• Large hedge funds have won more recent institutional investments than small hedge funds. While small hedge funds are usually penalized during a hedge fund due diligence or RFP process for having too many products with two few resources assigned to each, multiple product lines is one of the strengths that large hedge funds offer. Large hedge funds tend to have intentional risk control redundancy, teams made up completely of CFAs, PhDs and firm-wide systematic risk controls built into their portfolio construction and trading processes. In short, they have invested millions of dollars to ensure that the majority of their hedge fund strategies perform well on an absolute basis and outperform the general market by being superior risk managers. This size advantage over small hedge funds is magnified while markets remain choppy.

Kenneth Heinz, President of HFR recently commented, "In 2007, investors demonstrated a preference for established managers, as evidenced by the concentration of assets in the largest funds, with requirements for institutional infrastructure likely constituting a higher hurdle for new hedge fund launches."

• Q4 showed reductions in both hedge fund launches and liquidations, with 288 new hedge funds started and 154 hedge funds liquidated as reported by HFR. It is important to note that these numbers are off by roughly 20-30% due to small or "under the radar" funds that do not register with any of the large hedge fund databases. For the entire year of 2007 1,152 hedge funds were started while 563 funds were liquidated. Two interesting facts come out of analyzing this data a bit further. The average hedge fund was started with $30M invested, and the average hedge fund performance of liquidated funds was 5%. Many hedge funds close doors after losing key personnel or experiencing heavy losses within a portfolio. However many hedge fund close after the hedge fund managers who ran it decide to close shop while they are on top allowing them to disburse funds back to their presumably happy investors.

• Many institutional hedge fund investors say they are more afraid of headline risk than general hedge fund industry performance disappointments. Headline risk is usually referred to as the risk that the hedge fund you have in your portfolio makes national media headlines after blowing up.

• Financial Sectors have been hit hard and according to HFN is now one of the worst performing groups of hedge funds over the last two years. Over the last 12 months ending January 31st finance sector hedge funds are down an average 6.23%. With the finance sector itself being at the heart of recent economic and equity market troubles it may be some time before these funds move back towards former out performance as a group.

• More hedge funds are adapting and actively marketing more of a mixture of both quantitative decision making models and risk controls along with portfolio manager oversight and hands-on monitoring. This is being done for many reasons, one of which is that institutional investors often see strong risk controls at the portfolio level as one of the top 10 boxes to check before investing with a hedge fund manager. All else held equal this gives the larger hedge funds with far more resources an edge over small managers who are short staffed.

Asset Inflows and Outflows - The Big Picture

As of Q4 of 2007 the top 3 hedge fund strategies in terms of total assets under management were "Equity Hedge," "Relative Value Arbitrage" and "Event-Driven" with an estimated 27.15%, 14.63% and 13.07% of the market respectively. This may shift in favor of event-driven and global macro funds as some institutional investors are showing an increasing hunger for these types of hedge fund portfolios in the marketplace. Another interesting statistic that came out of reviewing 2007 asset flow data was that only 5.54% of all hedge funds have over $5B in total assets under management yet this small set of hedge fund managers hold over 59% of total hedge fund industry assets.

A recent report from HFN shows that the hedge fund industry gained over $194 billion in additional assets raising industry assets to almost $1.9 trillion. What will be more interesting is seeing what the net asset flow looks like after the end of Q1 here in 2008. While many hedge funds have beaten popular equity benchmarks, others have lost 10, 20 or over 30% of the value of their portfolio. Over the next 6 weeks we might see the result of some of these investors pulling some of their remaining assets with hedge fund managers out of this market. While this is the exception rather than the rule these types of events tend to spread bad PR within the industry causing more fear by those who are just becoming more comfortable with investing in hedge funds or alternative assets in general.

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.

2008 Crystal Ball

• BRIC (Brazil/Russia/India/China) strategies remain a popular choice by both institutional and retail investors as this set of countries is now riding the fence between true emerging and developed markets. One interesting point on this trend is that Brazil is being looked at more closely by many investors that have traditionally looked east in the past to China & India. This combined with some recent questions regarding the stability of politics in Russia could help propel record levels of investments into Brazil over the next 3-5 years.

• Hedge funds with over $300M in total assets and who have 5+ year track records and can sustain positive or near positive returns for the next 2 years should see their businesses thrive and win many new mandates in post recession market conditions. Investors always stress the importance of consistent positive performance during turbulent markets as being of paramount importance, even more important than benchmark crushing performance during healthy bull markets.

• Several hedge funds and equity have been formed to take advantage of relatively short-term price adjusted to real estate/debt instruments over the last two quarters. Expect to see a few stories of new found wealth as the result within 18-24 months once the markets have rebounded and the pulse of the financial sector returns to normal.

• Global Macro and event driven hedge funds will probably continue to do well versus both their hedge fund manager peers and long-only brethren. Goldman Sachs came out with a report in mid-March about how we have only seen 25% of the bank write-downs that are to come before this current financial sector storm is past. Global Macro hedge fund managers thrive during these periods of volatility.