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Hedge funds: Back to the future

by

19 Apr 2022

In a volatile and uncertain world, hedge
funds look appealing, but only if you
find the right fit. Andrew Holt reports.

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In a volatile and uncertain world, hedge
funds look appealing, but only if you
find the right fit. Andrew Holt reports.

Hedge funds are back. After a dramatic fall from grace, the picture for the asset class looks positive again. While, selloffs in 2019 and 2020 saw hedge funds report outflows of $17bn (£13bn) and $15bn (£11.4bn), respectively, according to the Alternative Investment Management Association (AIMA). Investors flooded back a year later as net flows reached $25bn (£19bn).

Breaking this down, family offices, foundations and endowments were the top investors in hedge funds. Moreover, 62% of family offices, 55% of foundations and endowments, and half of corporate pension schemes plan to increase their exposure to hedge funds in the year ahead. In comparison, 26% of public pensions intend to do so.

“Three years ago, many institutions were indeed adjusting their alternatives portfolios away from hedge funds. And often doing so vocally. They were making space for larger allocations to the likes of private credit and real assets,” AIMA’s report read.

“While the trend toward illiquid opportunities remains, we anticipate some positive changes with a renewed focus on hedge funds this year.” Predictably, on-going market uncertainty is helping to drive this. AIMA observes that investors have expressed concerns over equity valuations, with 35% wanting to use hedge funds as part of their allocation to public equities.

Another investor survey, conducted by BNP Paribas Asset Management, revealed that assets in multi-strategy funds are expected to enjoy the second-highest level of inflows of any strategy this year, behind funds betting on specialist equity sectors, such as healthcare.

On this picture, investors are expected to have met an average return target of 8.3% for their 2021 hedge fund portfolios – an impressive number.

As a result, more than half of the capital allocators surveyed plan to increase their hedge fund exposure by an average of $244m (£186.4m) this year, presenting a picture of real momentum heading into the asset class.

The long and the short of it

Asset owners and hedge funds have not always been natural bedfellows, but this is changing. Growing numbers are turning to hedge funds, given the macroeconomic uncertainty. A key example is almost half of US asset owners intending to increase their investments in hedge funds this year, AIMA says.

Based on this analysis, long-short funds are the most popular hedge fund strategy among asset owners followed by multi-strategy funds, then arbitrage and event-driven strategies. These range of hedge funds, show how asset owners can use them for their own purpose.

“These types of strategies have the ability to provide strong risk-adjusted returns with a low correlation to traditional asset classes,” says Joe McGuane, head of hedge fund research at California-based consultancy Callan. “They all have the ability to generate returns that are somewhere between equities and fixed income. They also have the ability to provide downside protection in times of stress for broad markets and generate returns when market volatility and dispersions are elevated.”

Geopolitical issues

Increasing allocations to hedge funds could be fuelled by a few factors: asset owners having a desire to diversify, or concern over the risks associated with persistent geopolitical tensions. Given the war in Ukraine, this is only going to intensify.

“For investors who have the ability and willingness to build a direct hedge fund portfolio, we favour multi-strategy funds due to their ability to dynamically allocate across strategies without involvement of the investor,” McGuane says.

On the comeback trail, according to research undertaken by BNP Paribas AM, quant equity and quant multi-strategy are also expected to make a big comeback. These strategies outperformed the overall hedge fund industry last year, having underperformed in the previous three years.

Interestingly, Asia Pacific and Europe are now the most sought after regions. Investors are looking to increase exposure to equity long/short funds in these regions and have also expressed an interest in expanding their European credit exposure.

Stern stuff

This comes after the US asset owner picture for the asset class is a positive one. It gives an indication of how pensions can exploit hedge funds in a way European counterparts probably have yet to fully grasp. “US institutional investors are acutely aware of the long-biased exposure they have in their portfolios to equities and fixed income,” McGuane says.

“They are now up to speed with hedge funds due to the funds’ ability to help diversify portfolios. “We suspect that US institutional investors like that hedge funds can go long and short across multiple asset classes,” he adds. “Hedge funds have shown the ability to opportunistically allocate capital as different markets become more or less attractive.”

As a snapshot, the $25.4bn (£19.4bn) City & County Employees’ Retirement System in San Francisco allocated, at one time, a whopping $1.1bn (£840.4m) across a number of hedge funds, although that has been cut back significantly.

The $76.6bn (£58.5bn) Oregon Public Employees’ Retirement Fund has $250m (£191m) invested in hedge funds. And the $54.2bn (£41.4bn) Maryland State Retirement & Pension System was an active investor in hedge funds pre-Covid, placing $200m (£153m) into Standard General’s event-driven master fund.

However, the US’ biggest public pension plan, the $500bn (£383bn) California Public Employees’ Retirement System (Calpers), has a different take on hedge funds. This is based on their fees being “problematic”, according to pension fund chief executive Marie Frost.

She is not alone in this concern, with many institutional investors citing charges as a key reason for not using hedge funds. That said, average hedge fund management fees have edged down in recent years from 1.5% of assets under management to less than 1.4%, according to data provider HFR.

This could also be seen within a wider context of hedge funds being placed as the villains of the investment world. Think the nihilism of the Joker from Batman, but with an expensive pad in California.

This narrative was played out when a group of retail investors clubbed together on social media platform Reddit and attacked hedge funds’, rather inexplicably, short positions on GameStop. But hedge funds are made of stern stuff and often thrive on the controversy that comes their way. This can be used by investors in a number of ways.

The traditional benefit argument of institutional investors using hedge funds is as a diversifier. “The primary objective of most hedge funds is to provide superior risk-adjusted returns with low correlations to traditional asset classes: stocks, bonds and real estate,” McGuane says.

Hedge funds achieve this by using a broad array of strategies to make investments in mispriced securities regardless of size, style or other sector classification. “Hedge funds also have the ability to provide downside protection when broad markets selloff in times of stress,” McGuane adds.

“When market volatility becomes elevated, hedge funds have a track record of being able to generate returns when dispersion is higher.” And this is a key part of why hedge funds can pay such an important role for investors in the current environment.

A complex asset

A big stumbling block for some investors is that hedge fund strategies can be complex and involve a variety of public and private assets as well as derivatives. This complexity can potentially add unique risks such as liquidity, transparency and leverage, as well as paying incentive fees, many of which are not usually present in traditional equity and fixed income investments.

“When investing in hedge funds, investors should consider whether the added complexity is worth the diversification benefit that a hedge fund brings to the overall portfolio,” McGuane adds. “Secondly, investors should consider potential customisation options available in structuring a hedge program, given the mandate size and program goals.”

Investors use hedge funds for a variety of reasons which is nicely summed up by Richard Tomlinson, chief investment officer of Local Pensions Partnership Investments (LPPI), which manages a range of funds across different investment styles and strategies.

“While we employ managers that may be classed by some as hedge fund managers, our objective in doing so is to focus on the risk premia and the underlying return drivers of the investment strategy, delivering returns which are independent of mainstream markets,” he says. But some question the validity of hedge funds.

FactorResearch founder and chief executive Nicolas Rabener says that the Credit Suisse Equity Market Neutral Index, which evaluates the alpha generation of hedge funds, has returned 0% over the 17 years between its inception in 2004 and 2021.

Breaking this down, Rabener presents some interesting analysis, noting that markets have become “highly efficient with few arbitrage opportunities left for exploitation”, making the running of a hedge fund extremely challenging.

The ultimate result, says Rabener, is that most hedge funds are in fact providing beta, because alpha is hard to come by due to rising stock valuations. He also asserts that investors are benefitting from improved analytics and data, which have enabled them to realize that many hedge fund strategies are “mere beta plays”.

So, the focus on low-beta strategies could be timely, offering protection against rising inflation and other volatility-triggering events. “Investors are increasing their allocations to low beta hedge funds that can achieve high-single-digit returns,” says Marlin Naidoo, global head of capital introduction and consulting at BNP Paribas.

On this theme, McGuane offers another perspective. “We are less favourably disposed to strategies exhibiting high and persistent beta exposures – long-biased equity or credit – concentrated or highly levered standalone niche strategies – convertible-only, mortgage-only, credit-only, regional or sector-only equity – and concentrated macro strategies, whether discretionary or systematic,” he says.

“Strategies that have lower beta to traditional equity and fixed income indices are the favoured type of hedge funds at Callan.”

Year of the hedge fund

The market outlook, with its many unpredictabilities, appears well suited to hedge funds this year, with some investors already turning to the industry to help benefit from – or at least see out – the macroeconomic, monetary and fiscal shifts already taking place that will be the hallmark of 2022.

And here there is a hedge fund for every season of uncertainty. “Hedge fund managers are positioning for continued volatility associated with the global pandemic, but are tactically focused on capital preservation across equity, fixed income and commodity markets, considering the powerful dynamics of rising interest rates and record inflation,” Kenneth Heinz, president of hedge fund analytical company HFR, wrote in a recent hedge fund report.

“Managers that have demonstrated the robustness of their strategies over the past two years will likely continue to lead industry performance and growth through the new year,” he adds.

On this note, aggregate hedge fund performance in 2021 was 10.3%, compared with 11.8% in 2020 and 10.5% in 2019 as measured by the HFRI Fund Weighted Composite – tasty numbers for investors by any measurement. And with one geopolitical worry after another, hedge funds can offer investor protection and then potentially profit from falling asset prices, offering investors a solid bellwether, as events, are inevitably, set to take their toll.

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