Coming off its worst calendar year loss in history, the hedge-fund industry enjoyed a strong comeback in 2009, as three separate indexes that track hedge-fund performance recorded gains of 18% or more. That didn't stop hedge funds from losing $131 billion through investor redemptions in reaction to the financial meltdown that began in 2008. But the money that remained was apparently put to good use, as a rally in the equity markets and more aggressive investment strategies produced the second best year for hedge funds in the last decade.Usually available only to more affluent investors, hedge funds are managed portfolios of investments that use aggressive investment tools such as derivatives in attempts to generate high returns. After losing more than $461 billion between 2007 and 2008, the hedge-fund industry ended 2009 with $1.6 trillion in assets, up $193 billion from 2008, but $268 billion below its peak of $1.86 trillion set in 2007.
The Hedge Fund Research Weighed Composite Index gained 20.1%, the Morningstar 1000 Hedge Fund Index grew by 19.5% and the Credit Suisse Tremont Index was up nearly 19% last year. This demonstrates that hedge-fund managers had successfully implemented investment strategies that were able to replace outgoing funds and still add high double-digit growth to their portfolios.
"The hedge funds that survived 2008's industry purge, or those that launched in the aftermath, picked up assets at rock-bottom prices and rode the recovery to near record profits, particularly in U.S. equity and debt markets," said Nadia Papagiannis, an alternative investment strategist at Morningstar.
The rally in the equity markets allowed many hedge funds to reclaim assets that were lost during a difficult 2008. Credit Suisse estimates that 83% of all funds in its index posted positive performance and 77% recouped their losses from previous "high water marks" achieved during 2008.
"Many of the fund strategies that were most out of favor in 2008 became top performers in 2009," noted Kenneth J. Heinz, president of Hedge Fund Research, Inc.
Willingness To Adapt
For instance, the Morningstar Emerging Market Equity Hedge Fund Index, which dropped 45.7% in 2008, was able to rebound 50.4% in 2009. Similarly, the Morningstar U.S. Small Cap Equity Hedge Fund Index, which was the second-worse performer in 2008, dropping 32.8%, recorded the third best performance in 2009, rising 36.4%. Morningstar said these hedged-equity strategies, which were hurt by a lack of liquidity in 2008, took off once liquidity returned to the market in 2009.
Heinz also notes that the hedge-fund industry helped itself by showing a willingness to adapt to investor behavior. As investors fled hedge funds because their risk for tolerance changed, the industry adjusted to get money flowing back into fund coffers. The once secret world of hedge funds has turned into an environment where Heinz says transparency has become the institutional standard.
"Funds have responded to investor demands by offering more specialized exposures, modified terms and greater transparency than pre-2008," he said.
What are stocks? Learn how to start investing.View Course »