Hedge Fund Investing: A Practical Approach to Understanding Investor Motivation, Manager Profits, and Fund Performance

Flows and Performance

Both the fixed-income relative value and credit arbitrage strategies expanded significantly during the bull market from 2003 to 2007. Investors seeking additional yield in a low-interest-rate and low-volatility environment were initially attracted to fixed-income relative value and then later to credit arbitrage strategies. Investors liked the stable values and better than traditional fixed-income or bond market returns available from these hedge fund strategies. As credit spreads narrowed and yield curves were inverted, hedge funds provided fixed-income investors an ability to generate higher returns than those available from traditional fixed-income and bond investments. The growth in fixed-income derivatives markets and credit default swaps also enhanced the ability of hedge funds to generate returns and mitigate risk where traditional investors could no longer do so without increasing risk. Institutional investors were familiar with yield curve and spread products and relative value trading in principle, excluding the leverage and short-selling components used by hedge funds. Investors easily understood the core products and strategies used by hedge funds and were quick to allocate capital to them from their cash pools or fixed-income portfolios.

According to data compiled by HFR, the strategy had only $150 billion in 2002. It grew rapidly to approximately $480 billion by the end of 2007 before contracting during the crash. At the end of 2011, the strategy ...