With hedge fund performance improving and pension scheme investment increasing, has more institutional backing resulted in greater transparency?
What does a typical hedge fund investor look like? Is it an individual with a few million quid to invest? Could it be the tube driver taking commuters to work, or the Tesco cashier helping customers with their weekly shop? If they are saving for their retirement, it might well be the latter.
While hedge funds do not come to mind when thinking of a typical pension fund’s investment allocation, UK institutional investors own almost half the sector at 43%. This dwarfs the mere 13% combined shareholding of high net-worth individuals and family offices, according to a 2015 Financial Conduct Authority (FCA) survey. Moreover, 51% of public pension funds globally are invested in hedge funds, a 2018 report by investment researcher Preqin revealed.
Yet over the past five years a combination of weaker performance and higher management fees has raised concerns over whether hedge funds are helping pension schemes achieve the best deal for their members or not.
In 2016, wealth manager SCM Direct published a damning report, outlining how the fees paid by pensions for hedge fund investments were 36 times higher than those charged by low cost alternatives, such as passives, whilst achieving as little as a third of the performance of an index-based strategy. The wealth manager estimated that in 2015 alone, UK pension schemes paid £2.85bn in fees and charges for their hedge fund investments.
Yet despite these criticisms, some institutional investors in the UK have gradually increased their hedge fund exposure, with ongoing return challenges driving investors up the risk ladder. The exact level of growth is hard to track, with some pension funds being notoriously reluctant to openly disclose their level of investment in hedge funds.
If they do, in annual reports for instance, they are generally re-branded as absolute return or liquid alternative strategies. For example, the Local Authority Pension Scheme LPFA, which has £5.3bn under management, has recently added total return strategies managed by hedge funds, including Winton Capital and GSA Capital Partners, to its investments.
For pension fund investors who are increasingly ambitious to become environmental, social and governance (ESG) compliant, the negative reputation of hedge funds remains a sticky point. Besides concerns over the moral value of hedge fund strategies, there is also the question of their tax compliance. Of the 132 funds included in the FCA’s latest hedge fund survey, 69% were registered in the Cayman Islands, while others are in Ireland, the Bahamas, the British Virgin Islands, Luxembourg or the US. No such funds were registered in the UK.
“There have certainly been some pension funds who have pulled out of hedge funds because they did not want to be on the front of newspapers,” Oliver Jaegemann, global mhead of Asset Management Exchange (AMX), says. “Investors want to know what kind of jurisdictions they are exposed to,” he adds. “If you are a large pension fund you do not want to be seen in the Panama papers. That is something hedge funds have had to get used to.”
THE TIDE COULD BE TURNING
In addition, the macro-economic context over the past five years, which was dominated by low volatility and inflated valuations due to central bank interventions, has reduced the prospect for hedge fund returns. Yet the onset of tapering and increased volatility might mean that the tide is now turning. Globally, the hedge fund industry has attracted $36.2bn in net in-flows in the past
four months, according to research provider Eurekahedge.
Last year, hedge funds offered average returns of 8.5%, with some equity-based strategies offering up to 13%, Hedge Fund Research data reveals. Willis Towers Watson global head of credit and diversifying strategies Chris Redmond argues that from a cyclical perspective, the mconditions where hedge funds are more likely to make money are now coming to pass.
“The post crisis environment was dominated by suppressed volatility as a result of quantitative easing, we are now starting to see greater levels of volatility and greater dispersion, which offers a lot of opportunities for hedge funds,” he adds. “This is why we have seen an improvement in hedge fund performance in 2017 and we think this will continue throughout 2018.
“We can paint a positive picture for the hedge fund space and we have certainly been talking to our clients about allocating more money.”
Advocates of hedge fund investments point out that the industry has matured since its early days, and is now a lot more accessible for institutional investors. For Jaegemann this means that the days where hedge funds lacked transparency and had lax reporting standards are gone. “Investors are simply no longer willing to accept that,” he says.
Stephen Oxley, vice chairman at alternative asset manager PAAMCO, says: “Hedge fund fees have come down over the last 10 years, five years; three years despite that there continue to be worthwhile active management strategies that carry with them higher fees.
“And if on the one hand the pension fund has a policy of diversifying its portfolio exposures but on the other hand has a strategy of cutting out active managers like hedge funds to save money, that can reduce the net expected risk-adjusted return,” he adds. “Some are moving towards lower cost liquid diversifying strategies, for example alternative risk premia, which arguably reduce fees and provide diversifying benefits.”
For Steven Daniels, chief investment officer of the Tesco Pension Scheme, which had £13.1bn of assets in April, transparency surrounding a fund’s strategy and fees are a minimum requirement for any potential investment.
“We have certainly continued to make fund investments with hedge funds who have ‘grown up’ and who are able to talk to us. “We don’t want to know every last deal, but we do want to know that they are doing what they said they were. There are others who have refused to listen and have exited our portfolio,” Daniels adds.
At the same time, he remains sceptical on whether the hedge fund industry has adapted enough. “In terms of fees there has certainly been some progress, but I am probably not the only institutional investor who believes that a lot more needs to happen. What we are not happy about is if return is achieved through a lot of leverage, which is not particularly skilled.
“Using our money to make a gross return of maybe 7% or 8% and delivering us a net return of 3% or 4% is not acceptable,” Daniels adds. “At the end of the day, the manager is using our member’s money, which is at risk. There is quite a need for alignment between hedge funds and institutional investors.”
He also remains cautious on the ESG-compliance aspect of hedge funds: “As the internal manager of the Tesco Pension Scheme we have a mandate from the trustees. As part of that we have agreed strategy which does include using hedge funds but also we have ESG responsibilities and we have to continually check that managers we invest with are appropriate in the circumstances.”
Looking at the distribution side, another defining shift for the industry is that hedge funds are increasingly accessed through managed accounts. For Andrew Allright, chief executive of Infrahedge, and AMX’s Jaegemann, who work with managed account platforms, this is testament of the growing power institutional investors have to shape the industry.
“According to a recent Credit Suisse report, more than half of new asset flows into hedge fund investments are now coming in through non-traditional vehicles (withMAPs being the largest beneficiary), the market is definitely moving into that direction,” Allright says. “The institutional investor now has much more power than they used to have, hedge fund managers are increasingly willing to consider managed accounts in order to cater for the customised investment solutions they are demanding,” he adds.
“Institutional investors are increasingly opting for managed accounts; which is why we set up AMX in 2017,” Jaegemann adds. “Those large institutions make allocations for a very specific reason, often putting together an entire portfolio of strategies.” For investors, the benefits of managed accounts are that the platform oversees a hedge fund’s daily trades, provides oversight fund operations and governance as well as risk analytics and investment compliance services.
“In a managed account you can negotiate the investment limits guidelines to be very specific; access to daily information makes sure the manager is not doing things they shouldn’t be doing,” Allright stresses.
As part of this drive for transparency and lower fees, the range of hedge fund providers has become increasingly concentrated, with institutional assets largely held among a few big firms, such as Bridgewater Asset Management, Blackrock or AQR. This, in turn, raises the question of whether such big firms defy the definition of a hedge fund.
Oxley argues that if larger firms were excluded, the size of the hedge fund industry could be significantly smaller. “The defining features of hedge funds are that they are skill based, they try to reduce mdownside risk, charge an incentive fee and the managers usually have skin in the game. Usually they focus on a particular market segment or hedge fund strategy.
“To us hedge fund managers are more boutique- style firms which have experience making concentrated but hedged investments,” he adds. “They may also be new or emerging so there should also be an entrepreneurial element to it. The more institutional, established larger firms offering hedge fund strategies tend to grow more quickly, particularly because institutional investors tend to gravitate towards them.”
For Jaegemann, the concentration of hedge fund providers is a worrying trend, which he aims to challenge through his platform. “It is not a good thing for the industry if only big guys like Blackrock and State Street are able to start new products. “As the range of fund providers is becoming more concentrated, we need to start thinking about new business models, where a start-up with £50 can launch a fund because they get the infrastructure through a managed account platform.”
Others, such as Infrahedge’s Allright, think that bigger asset managers could be considered part of the hedge fund industry. “ Investment strategies are becoming increasingly blurred with long only managers taking on hedge fund mandates; hedge fund managers operating in the private equity space, and vice versa. Investors are therefore looking at the underlying fundamentals of the strategy to put it in the appropriate risk bucket of their investment strategy,” Allright says.
Going forward, the definition of what constitutes a hedge fund is likely to become even more blurred, with more and more asset managers adopting strategies traditionally associated with hedge funds, from using leverage to charging performance fees or applying long-short strategies.
For Tesco’s Daniels this means that what is or isn’t a hedge fund becomes less relevant. “Within the entire alternatives portfolio that we have we still have hedge funds but we think about them very much based on those risk and return criteria. The label ‘hedge fund’ as such is a meaningless for us, what matters is the process to consider an investment opportunity, we want to understand
the source of income and what kind of capital flows we can expect to get back over time,” he argues.