October redemptions largest yet for hedge funds

Industry experiencing crisis of negative investor sentiment

Investors redeemed an estimated net $17.2 billion from hedge funds in October. Year to date (YTD), there has been net $80 billion removed from the industry. October's outflow was the fourth month of redemptions in the past five and the seventh of 2016. Because of the breadth of products experiencing outflows and the persistence of redemptions outweighing new allocations, it is clear the industry is experiencing a crisis-like wave of negative investor sentiment.

The breadth of redemption pressure in October was the industry's largest in 2016, with 61% of reporting funds estimated to have net outflow during the month. The past five months have accounted for the majority of the industry's redemptions in 2016, a timeframe that aligns with investors' processes for analysing 2015 results, and taking actions on those decisions.

While investors broadly reduced investments in hedge funds in October, the bigger issue was the lack of meaningful new investment. The portion of funds losing greater than 2% or 5% of their assets under management (AUM) from redemptions was only slightly above average in October, although the portion with new allocations greater than 2% or 5% of their AUM were well below average. Essentially, flows in October were poor, not necessarily because investors redeemed from the industry, but because no-one is really allocating with any enthusiasm.

A major issue that arose in October was that investors are turning their backs on the one segment that supported industry flows in 2016, managed futures. Performance issues, as anticipated, appear to have swayed investor sentiment. After aggregate performance declines in each of the past three months, and six of the past eight, managed futures funds had their second-largest month of outflows in almost two years in October. With performance losses intensifying in October, the outlook for flows for the universe is poor.

The outlook for macro hedge funds may actually be positive, despite October being the tenth monthly net outflow for the universe within the past year. Eight consecutive months of positive asset-weighted performance, against the backdrop of a rapidly evolving macroeconomic landscape could be good for flows. There remains the risk for investors of selecting managers that most appropriately interpret global influences, however, as the universe has proven that not all will get it right, and several may get it very wrong.

Distressed – the industry's best-performing strategy of 2016 – had slightly positive flows in October. Distressed investing, in a hedge fund structure, endured 22 months of negative investor sentiment prior to October. The interest in private credit funds, whose structures are designed to be specifically aligned to opportunities in distressed or special situation credit markets, have likely had an impact on distressed hedge fund net flows.

Event-driven funds continue to be a major source of redemption pressures for the industry. October and YTD flows by size and prior-year return illustrate the issue well: too many large funds performed poorly last year, and they have been the major source of redemption pressures through the year and into October. Why that occurred is particular to each fund, but the negative sentiment in response has been universal.

August marked 15 months of investors favouring commodity strategies, but after recent losses, investors have begun to head to the exits. Redemptions in October were the second consecutive month of outflows after persistent losses re-emerged in July.

Interest in emerging markets (EM) exposure, which had been a source of hope for one segment of the industry, dwindled in October. Although there were fund-specific areas of interest, no sub-universe (China, Brazil, India, emerging Europe, broad EMs) had aggregate net inflows.

Investor flows for China-focused funds returned to levels seen earlier in the year when sentiment was universally negative. The very slightly positive flow in September appears right now as an anomaly. Given the level of uncertainty around actions towards trade and foreign competition surrounding newly elected officials in the US, it is doubtful we will see fresh allocations to China exposure in the near term.