Fighting a forgotten war?

28 Jan 2019

At the end of the last decade, several factors converged on the hedge fund sector that threatened to spoil the high-octane party of the previous 10 years. Despite some stellar returns, investors were finding the fees increasingly expensive, while others took issue with the opacity around strategies and holdings. Some worried that these funds might not be very liquid in high stress scenarios and wondered how they would react in a crisis.

Just before the decade concluded, many of these fears proved to be right. As the financial crisis developed and markets began to crash, plenty of hedge funds were undone. Gates were erected to stop investors pulling money out of funds that were unable to liquidate securities at short notice, while others were shown to be entirely correlated with equity markets. All the while, many investors found themselves paying exorbitant fees for losing just a few basis points less than their traditional mutual fund managers – or losing their assets completely.

If a hedge fund is earning you double-digit returns, to a certain extent, you care less about the cost.

Mark Walker, Coal Pension Trustees

Into the breach of this catastrophic display stepped liquid alternative funds, which banks and asset managers had been cooking up behind the scenes for a couple of years while watching an increasingly uncomfortable investor base. Wall Street’s finest, including JPMorgan, Merrill Lynch, Goldman Sachs and Credit Suisse, created vehicles that had all the perceived upsides of the hedge fund universe, but with none of the pesky illiquidity, opacity and high fees.

By using a wide range of derivatives, these funds were able to replicate the average performance of many of these hedge fund sectors, without getting caught in the same bind as the originals.

It seemed like a great idea, especially with equity markets showing no sign of recovery. A flurry of investor assets, once free from their hedge fund gates, flew into these funds in the UK and US, along with some on mainland Europe, according to Morningstar.

And that should have been the start of the success story – but it wasn’t. By 2015, the show was on its way out of town.

Mark Walker, Coal Pension Trustees’ chief investment officer, says that he remembers these funds being marketed while running the Unilever pension schemes, where managers claimed they could generate hedge fund-like returns for drastically reduced fees.

Walker says he did not take up the investments as there were two points that turned him off. “Firstly, I recollect they tracked a peer group average, when we were aiming for a significant margin over this measure,” he adds. “At Unilever, we had a specific long-term return target over cash and a shorter-term peer group success measure. If we could not beat that, what was the point? It is the same with these funds. Why only aim to be average?”

Walker adds that there were also issues with the data being used to construct the indices used by the funds, including a survivorship bias that skewed the numbers. “Yes, they were being offered at a lower cost, but the returns were lower than we expected,” he says.

And if the projected and expected returns were not enough to turn an investor’s head to begin with, their recent performance has not done enough to keep them interested either.


Brian Kilpatrick, a former head of the Marks & Spencer Pension Scheme and now a director at Law Debenture, says that the experience of these so-called hedge fund clones had been a function of how quantitative easing (QE) had impacted markets.

“They seek to exploit a range of ‘alternative’ persistent betas which arguably may have historically been regarded as alpha,” he adds. “Through QE and the lower asset return premia and volatility there has not been the usual opportunity set this type of strategy seeks to exploit.”

What none of the banks and fund managers could have predicted in the throes of the financial crisis was the reaction of central banks, which has been a major stumbling block to the success of liquid alternatives. Kilpatrick says that the returns on equities since the crisis have been high. “People have been frustrated with the returns they have been getting from many absolute return funds, hedge fund replicators and relative value diversified growth funds, which target equity-like returns, but at a lower risk,” he adds.

Another pension fund investor said these funds were still being marketed, “but given how well equity markets have done in the recent past, and how poorly a lot of these strategies have performed, they are difficult to justify”.

In October, Wilshire, a consultancy, said the sector’s performance was down 2.77% that month, adding to a forgettable year.


The real kicker for these funds is that while they have been forlornly seeking assets, those they were meant to replace have been firing up again. In 2016, hedge funds recorded their first year without a monthly loss since 2003, according to data monitor Hedge Fund Research – and the assets soon followed.

Depending on whose data you choose, assets in “mainstream” hedge funds surpassed a record $3.4trn in 2018, despite investors fleeing those focused on emerging markets.

Their cloned cousins have continued to fade, however. Data from Morningstar shows that from an organic growth rate of more than 37% in 2015, it had sunk to 14% by the end of 2017 and shrank over the course of 2018, too.

“These funds have been like fire insurance when the fire never happens,” says Jason Kephart, senior analyst at Morningstar. “Also, people have grown impatient. These funds are producing low returns in a bull market, where it is costing people money to own them.”

Walker at Coal Pension Trustees says that even if the issues with the benchmarks and their constituent parts had been resolved, there remained an issue about the performance of many hedge funds since the financial crisis, too. Despite some standout performances, there was an oversupply of mediocre funds that were not helping the sector’s overall image. With an equity bull market strengthening since 2012, many investors have been happy to stay with more mainstream assets.

“If a hedge fund is earning you double-digit returns, to a certain extent, you care less about the cost,” Walker says. “While fees are coming down in some areas of the hedge fund market, so have the returns – and that also feeds into the peer benchmark being used by the alternative funds.” Another issue for large institutional investors has been the paucity of funds available. While there are plenty of hedge fund managers and other types of investors, the liquid alternatives market functions on a “winner takes all” basis, according to Kephart, “where five funds took all the assets and a further 50 got next to nothing”.

This is a significant point for large investors, who seek to invest a relatively large ticket size because of the due diligence involved.

Kephart said these investors were not keen to be a major shareholder in small funds – often their investment terms and conditions do not allow them to be – which leaves only the largest funds to choose from.

This problem has only been compounded by the lack of staying power displayed by the funds. Morningstar research in May 2018 found the four categories with the highest rate of fund “deaths” over the past five years fell under the liquid alternatives umbrella. Around a third of funds do not make their fifth birthday, according to Kephart, with almost as many never actually gaining a three-year track record.


An additional concern for investors, who are keenly eyeing a record bull market and a flexing yield curve, is that these liquid alternatives have not been tested in a downturn.“There is still a nervousness amongst our decision makers about leverage and the use of derivatives and what would happen in times of stress,” says Chetan Ghosh, chief investment officer of the €8.5bn Centrica pension schemes. “While some of these fund strategies have intellectual merit, many investors want to see how they react in a full market cycle. Whether they would pass a live test.”

He adds that there was also some evidence that in a mild sell off, algorithmic strategies actually add to its ferocity. “That is disconcerting,” Ghosh adds. “We have a watching brief on it.”

However, there could be a glimmer of hope for these alternative funds – should they pass the live test of a market correction.

One pension fund investor said the enhanced liquidity meant they could get some traction with defined contribution (DC) investors, but this would have to be tested in a downturn situation before any platform or master trust would accept them as an option for members.

For Kilpatrick, if volatility returns to the market there could be opportunities for the vehicle, but it still has a lot to prove. He also thinks investors have become more comfortable with illiquidity, which is now being exploited in credit and other debt funds – vehicles that were also created in reaction to the financial crisis but have had more success. “As bank regulations have reduced the amount of corporate and real estate lending their available capital can support, the asset management industry has developed a number of investment strategies to deploy capital into these areas creating new opportunities for investors,” he says.

Kilpatrick adds that there was “a material amount of money” that has gone into these funds, which typically have a degree of illiquidity with a tie up of five years but with “relatively attractive expected returns”, which is what has failed liquid alternatives.

If more investors become worried about equities falling, liquid alternatives might get some attention, according to Walker at Coal Pension Trustees, but he warns that fund managers should be getting back to basics and “asset classes with strong fundamentals” rather than create a discounted copy of something that is already out.

These funds have been like fire insurance when the fire never happens.

Jason Kephart, Morningstar

“There is no problem with managers trying to deliver diversified returns at a reasonably low cost, but you may be better off finding a manager that is likely to outperform, if you can,” Walker says. “Many managers are middle-of-the-road; you are better off not bothering with them.”

However, if some do pick the right strategy to weather the next crisis – and no one will know what it is until it hits – it could save the sector, says Kephart at Morningstar.

“Success breads envy,” he adds. “If they get the performance, the assets will follow. If they don’t, they won’t. They are new compared to many other asset classes and have to go through a period of trial and error.” If central banks had acted differently and the illiquidity crisis had stayed in town for longer, it might have been a different story. “They seemed like a good idea at the time and diversification does make sense,” Kephart says. “But can these funds deliver or have they just missed the boat?”

For all their good intentions, liquid alternatives might still be fighting the last war, when investors need to prepare for the next one.

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