Inflows into hedge funds decreased 42% year-on-year in the first quarter of 2008. Market volatility made investors less inclined to invest in the asset-class as hedge fund returns dropped 2.99% in the first quarter compared to a 1.64% gain in the fourth, according to Morningstar.

Only four of 17 hedge fund categories generated positive returns since the beginning of the year. The biggest winners were in the short equity fund category which returned 13% followed by global trend funds which produced an average return of 11.3%. Global non-trend funds returned 1.69% while equity arbitrage funds averaged 0.33%.

The biggest losers were hedge funds that invested in emerging markets equity (-8.76%) and Asian equity (-5.28%). While most hedge fund strategies posted negative returns, the S&P 500 lost 9.9% during the same period.

Merger arbitrage

Inflows into hedge funds are well below their peak levels of early 2007; nevertheless, the totals still represent $41.2bn inflows into the asset class, according to TrimTrabs Investment Research. For the second consecutive month, emerging markets was the largest asset gatherer in March, posting an inflow of $3.4bn. Conversely, merger arbitrage has seen $8.3bn in outflows since last October.

“We believe the cancellation of several high-profile deals in Q4 led investors to believe that merger arbitrage is no longer a promising strategy,” notes TrimTabs. “Yet plenty of strategic deals are being announced in the US while cash mergers in Europe have reached record levels. The strong returns of merger arbitrage seem to contradict the notion that the strategy is no longer viable.” Indeed, the annualised returns of the strategy have been 15.9% since October which exceeds all other hedge fund strategies.

Even adjusting for risk, merger arbitrage was ahead of other strategies, posting a Sharpe ratio of 1.81 compared to -.56 for the hedge fund industry. “If the hedge fund market is efficient, those two strategies should receive the bulk of new investments into hedge funds in the coming months,” according to TrimTabs.

The findings are based on a database which covers more than 5,500 hedge funds. The data indicate that investors were less likely to invest in smaller hedge funds (those with less than $200m in assets). In the last eight years, flows were fairly equally distributed across hedge funds of various sizes. During the past six months, however, investors favoured large hedge funds over smaller ones.

VB