Talking Fund Flows With HFR's Josh Rosenberg

He attributes the first industry outflow to fed-up funds of funds.
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Potential investors in hedge funds always find it challenging to find performance data on managers. The reason is simple. There is no central registry, and funds are under no obligation to disclose their returns. Even the new

Securities and Exchange Commission

registration rule does not require managers to announce their performance. Private databases and index providers are therefore the main source of information for investors. With more than 5,300 hedge funds and fund of funds actively reporting their data and performance information to them, Chicago-based Hedge Fund Research is one of the best established sources of data and research for the industry. We asked its president, Joshua Rosenberg, to talk about industry trends and performance. For the first time in 10 years, hedge funds experienced a quarterly outflow last quarter. Can you explain why?

Josh Rosenberg

: Hedge fund asset flow has been steadily decreasing last year, with inflows of $27.4 billion in the first quarter, $10.9 billion in the second quarter and $9.4 in the third quarter. In the fourth quarter, hedge funds recorded an asset outflow of $824 million. While flows into hedge funds had been at record levels prior to the first quarter, hedge funds suffered a significant slowing trend in the latter half of 2005. We believe that some investors -- primarily funds of funds, which make up over 38% of hedge fund assets -- are clearly unsatisfied with the somewhat mixed performance over the past several quarters.

In terms of fourth-quarter flow, the very poor performance of October certainly did not help. There were also some fairly sizable withdrawals at some larger hedge funds. Despite the fourth-quarter outflow and a general slowdown of flows, hedge funds still managed to record $46.9 billion in total inflow in 2005.

Funds of funds inflows have slowed. Can you quantify that and explain the reasons behind this trend?


: Funds of fund inflows have also slowed substantially from record levels in prior years. In fact, funds of funds recorded an outflow in the last two quarters of 2005, with assets of $1.2 billion leaving in the third quarter and $2.1 billion taken out in the fourth quarter. Declining yearly flow levels reflect this slowing trend; flow for funds of funds in 2005 was just over $9.5 billion, while inflows had hit $53.4 billion and $33.1 billion in 2003 and 2004, respectively. While flows into funds of funds have clearly been affected by mixed performance results by single-manager hedge funds across the major strategies, what our data has been showing us over the past several quarters is a systematic move in assets out of funds of funds and into multi-strategy hedge funds (event-driven and relative-value funds, for example). Single manager multi-strategy funds enjoyed yearly asset flow growth in 2005 and 2004, due in part to the funds' ability to lower risk by having access to a broader range of investment styles.

On those funds that report to HFR, what is the proportion of those that stop reporting and why?


: About 1% of funds that reported to the database in 2005 ceased reporting. This was due to a variety of factors, including simple liquidation of a fund's assets or a fund becoming closed to new investments. When a fund ceases to report, we then log that fund's entire performance history and fund profile into our Dead Funds Database, which we make available to researchers and other HFR customers.

Let's talk about the 2005 performance. At around 9%, results are flat compared to 2004 but lower than the 19% seen in 2003. Why the two-year slowdown?


: The past eight quarters have been marked by historically low levels of volatility and poor performance in the equity markets. These factors, coupled with a very difficult interest rate environment, have resulted in very mixed performance across the board for hedge funds.

Your hedge fund index shows a substantially higher overall performancenumber than some of its peers. Why?


: All indices take into account a different number of funds and employ a variety of methodologies. The HFRI Composite Index, whichrecorded a 9.35% performance for hedge funds, is a monthly average performance composite index calculating the average rate of return over 1,800single-manager, U.S. dollar-denominated hedge funds operating in 32 distinct hedge fund categories. In order to analyze the various monthly performanceindices, one must use an apples-to-apples comparison with other monthly performance indices that calculate average hedge fund performance across asimilar number of funds and strategies.

What were last year's best performing strategies?


: Due to the combined strength of equity markets abroad, equity hedge funds were one of the best performing of the major categories, finishing the year at 10.7%, while emerging-markets funds hit 20.1%. Energy funds, taking advantage of volatility in the global oil and energy markets, recorded combined returns of 22.5% in 2005. The relatively few market-timing funds did fairly well during 2005 and have avoided the negative press they received during prior years.

Convertible arbitrage was the worse strategy, with outflows of $7.66 billion. Any sign of recovery?


: Significant outflows and poor performance in convertible arbitrage during 2005 have led to one of the strategy's worst years in terms ofasset growth. Performance has picked up, however, in the back half of the year, which could lead to a turnaround at least in terms of asset flow.

Hedge fund activism is growing in popularity. Any chance to come up with a measure/index tracking the performance of this strategy?


: We are currently looking into ways to accurately categorize and represent the performance of activist hedge funds as a category.