After a year of continuous outflows, total hedge fund assets rose 5.8 per cent in May, with 1 per cent attributable to net investor inflows and 4.8 per cent to returns, according to a fund of hedge funds sector update from Standard & Poor’s Fund Services.

According to lead analyst Randal Goldsmith, S&P Fund Services estimates that on aggregate FOHFs returned around 5 per cent in the second quarter of the year and 6 per cent year to date, based on the returns posted by the funds covered by the firm.

S&P Fund Services’ analysis shows that across the underlying hedge fund strategies each individual strategy delivered a positive return in May apart from short biased. Among the month’s big winners were distressed strategies - which had their best month for over 18 years, returning 6.1 per cent - and emerging market hedge funds, which having gained 10.2 per cent in May were the month’s strongest strategy.

Mr Goldsmith points out that FOHFs were slow to catch the turn in March after reducing net and gross exposures to historically low levels. Although gross exposures remain low, S&P has noticed net exposures within long-short equity hedge allocations moving up significantly, he said.

In S&P Fund Services’ view, investors have been quick to respond to disappointing returns, but have been slower to react to improving performance. Trust in the sector has been badly damaged, with liquidity issues being a particular source of grievance, and according to S&P Fund Services investors’ wariness of hedge funds is attributable to this disappointment.

A recent KPMG survey suggests that improved communication with investors is needed to rebuild trust in the hedge fund industry, but in Mr Goldsmith’s view many FOHFs – which may have suspended redemptions or created side-pockets -  need to address other issues first. “FOHFs that have restricted investor liquidity have a lot of work to do on their process and structure before stepping up communication,” he said.

That the FOHF industry has taken a mauling over the past year is certainly borne out by S&P Fund Services ratings activity: the firm said that over the last 12 months the vast majority of its ratings actions have been negative.

S&P Fund Services said ratings have been taken away from over 10 per cent of FOHFs for poor liquidity management as the firm does not rate a fund that has over 20 per cent of the portfolio in a side-pocket or where dealings are suspended. Weaknesses in risk management processes related to exposure to the Madoff strategies were also cited as a reason for the withdrawal of ratings.