By Andrew McCaffery
Last week two completely different stories caught my eye. The first was the news that a flurry of pension schemes are selling down their allocations to hedge funds citing cost and performance. The second story was the release of the annual league table of super brands including iconic businesses, such as British Airways, Apple and Coca-Cola. Whilst never likely to challenge these global giants it struck me that hedge funds could do with a brand refresh.
Despite a compelling long-term track record, the perception of the industry is built around high fees, millionaires, Ferrari driving fund managers and average performance, particularly during and in the aftermath of the financial crisis.
High fees and poor performance is not a compelling proposition. However, hedge funds have actually made significant progress in terms of the former. Recent analysis by Aberdeen’s hedge funds team indicated average management fees at nearer 1.6% across the industry. The historic ‘two and twenty’ model – 2% annual fee and 20% performance fee on outperformance – is a thing of the past with only managers who have a consistent track record able to levy it.
But treating hedge funds as one broad category is overly simplistic, and not at all helpful. The differences result in large dispersions of returns, both across and within hedge fund strategies. It is here that we start to get to the nub of the issue: understanding the characteristics of different hedge fund strategies and distinguishing the ‘quality’ of the hedge fund, the ‘quality’ of the returns and the opportunity set within the strategy, and then knowing when to invest in them.
We looked at the question of hedge fund fees in detail a year ago and in November 2013 published a paper entitled: “Hedge fund fees – does it pay to pay?”, where we explored these issues in much greater details. To summarise, the report highlighted that for investors seeking to access higher beta strategies, cheaper opportunities clearly existed in the long-only space. However, if an investor seeks absolute, uncorrelated and low beta sources of returns, then, on average, funds charging higher fees produce better-quality returns than their lower fee counterparts. However, what was also clear is that within the higher fee bracket, there was a wide dispersion of returns, bringing the importance of manager selection to the fore.
In practice this is far easier said than done, and so investors often focus their attention on more tangible factors such as cost and performance. The dangers here are manifold. First, one should consider the diversification benefits that a strategy can offer, strategies that are less sensitive to traditional asset classes could be viewed as higher quality by exhibiting lower correlation to major indices. Next to consider is the quality of the return, if a fund can offer strong risk-adjusted returns this also brings significant benefits to an investor.
Hedge funds need to address the poor image they have. Some of this can be done by being more transparent in terms of fees. But managers also need to articulate better the diversification benefits and risk-adjusted returns offered by hedge funds. The next few years is predicted to see a continuation in the growth of allocations from pension schemes to alternative asset classes, hedge funds need to address these issues to ensure they continue to remain relevant.
Andrew McCaffery is global head of alternatives at Aberdeen Asset Management
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