Hedge funds pressed into new role

Troubled by a sense that pickings from equities and bonds are set to be slim in the coming months or years, private bankers are seeking solutions in the unconventional world of alternative investments, and hedge funds in particular.

They emphasise, however, that far from representing the ultimate high-risk solution to the desperate search for yield, hedge funds can be used in a relatively low risk way to enhance returns.

Hedge fund managers have lost their status, among private clients, as the rock stars of investment management – brilliant but erratic investors, capable of producing spectacular returns but with a large dose of extra risk. There is also considerable cynicism about hedge funds’ ability to provide a positive return regardless of conditions in the broader market. These days, hedge fund managers are regarded – when they are doing their job properly, at least – as reassuringly boring technocrats.

“Clients are not really responding to the supposed hedge fund benefits of alpha and absolute return,” says Didier Duret, chief investment officer at ABN Amro Private Bank in Amsterdam. “That’s totally passé. We believe, instead, that hedge fund investment is about using specialist managers for specific reasons.”

For many private bankers, these specialist hedge fund managers have been enrolled to help them find a solution to the twin problems posed by bonds and equities. Yields on fixed income are too low for clients, but many wealth managers think that after the long bull run in equities since the beginning of 2013, there is limited room for further stock price growth and ample room for falls.

“Returns on fixed income have been low, and returns on equities are getting lower too,” says Cesar Perez, chief investment strategist for Europe, the Middle East and Africa at JP Morgan Private Bank in London. In response, the bank has progressively raised its allocation to hedge funds since early last year from 5 to 7 per cent of the portfolio.

JP Morgan has allocated funds to specialist strategies that offer higher returns than fixed income, but have only limited beta to the equity market. These include equity long-short and event-driven, making a return from trading corporate events, such as mergers and acquisitions, that will push the stock price of a particular company up or down.

Equity long-short strategies often have a mild positive correlation with stockmarkets, rather than being totally market neutral, because the funds have a proclivity towards a slight long bias.

The beta for event-driven can be high, but JP Morgan has limited this by increasing allocation to managers who specialise in the lower-beta strategy of profiting from merger and acquisition activity only after the first bid by a would-be acquirer, rather than the higher-beta strategy of speculating on which companies might be bid for in the first place.

For the hedge funds which the Private Bank uses to invest in these strategies, Mr Perez estimates the beta to stockmarkets as only about 0.3.

The bank has also put money in distressed debt, in the hope of a higher return than for other forms of fixed income.

However, just as JP Morgan increased allocations in early 2013 as yields on fixed income fell, Mr Perez plans to reduce allocations if, in line with his prediction, yields start to rise later this year.

JP Morgan also allocates up to 5 per cent of portfolios to private equity, with Mr Perez noting the market is not liquid enough for higher allocations. Many private bankers believe private equity currently looks good value compared with public equity, but most are wary of devoting huge resources to it. This is largely because many clients already have large private illiquid assets outside their portfolios, including companies and property.

There is a need to invest in hedge funds that “can provide a cushion for any correction in equities, after their long bull market,” believes Nicolas Campiche, Geneva-based CEO of Pictet Alternative Investments. Pictet, which advocates hedge fund allocations of 15 to 20 per cent for mid-risk portfolios, with a slightly lower allocation for those clients who also have private equity and real estate holdings, is using long-short funds to do this.

For fixed-income, Mr Campiche sees an important role for hedge funds in providing “risk premia not accessible through traditional asset management”. Distressed funds have, over the past 15 years, posted annual returns of between 9 and 20 per cent net of fees, he says.

Current returns are, he acknowledges, closer to the bottom end of this, because many of the larger opportunities in the US, the biggest market in distressed credit, have now disappeared. However, given low bond yields, “distressed funds still offer a significant premium to conventional fixed income”. He sees opportunities in smaller US assets, and in Europe.

When it comes to hedge fund credit solutions to the low returns on conventional fixed income, Citi likes strategies that take advantage of the likely move upwards of the longer end of the US interest rate curve, because of the unwinding of monetary easing by the Federal Reserve, says Iain Armitage, head of investments for Emea at Citi Private Bank in London.

For example, it recommends a fund which uses a combination of strategies that could profit from this, including the use of swaps, swaptions, and the buying and selling of the large and liquid US municipal securities market.

When it comes to hedge fund equity strategies, Citi holds a strong belief that developed markets will outperform emerging markets. Responding to this, it likes funds that might invest in the outperformance of European stocks more reliant on developed market income over those more reliant on emerging market income.

Rising allocations

Citi’s allocation to hedge funds, for a matter of years, has been 16 per cent for mid-risk portfolios. “We are feeling reasonably satisfied at the fact that other private banks are increasing allocations to hedge funds after we did,” says Mr Armitage.

Given this new view of hedge fund managers as dull technocrats rather than exciting party animals, private banks see no reason why hedge fund allocations cannot go even higher than they are now.

“We regularly review our allocations, and I could absolutely see hedge fund allocations going higher,” says Mr Armitage. “But that does not mean we are saying, ‘we should be investing more in risky assets’. Hedge funds are not just about risk.”

In a sign of how far the role of hedge funds has changed, ABN Amro Private Bank has gone slightly overweight for its lower-risk investors. Because of the relatively larger bond weightings in their long-term strategic asset allocations, lower-risk investors are “enormously sensitive to interest rates”, says Mr Duret.

“We need to diversify that by going underweight in bonds and investing through hedge funds,” he concludes. These investments include credit arbitrage strategies, such as trading on the price differences between credit default swaps and the underlying bonds, and event-driven funds based on M&A activity.

ABN Amro and other wealth managers have, therefore, persuaded clients who are cynical about alpha-male managers producing alpha return, that hedge funds can play a less spectacular but possibly even more valuable role than before. However, a minority of private banks have, in the wake of the credit crunch, concluded there is little role for hedge fund managers at all – whether as rock stars or technocrats.

Julius Baer currently has “almost no hedge fund exposure” in its main discretionary investment strategies, and hence in most private clients’ portfolios, says Daniel Kerbach, head of portfolio management at Bank Julius Baer in Zurich.

This lack of interest in hedge funds derives, ultimately, from a fundamental rethinking of the bank’s investment process in 2012. The bank has decided to dispense with benchmarks for most clients. Instead, it concentrates on investing in assets that offer three virtues: income, diversification and recoverability – the robustness of investments over the investment cycle.

Given that off-benchmark investing –largely in pursuit of goals similar to Julius Baer’s trinity – is partly what hedge funds do, Mr Kerbach is sceptical about the bank’s need to use them. “I would say that for the most part, hedge funds are a style of investment, not an asset class,” he says. “We are therefore partly able to get similar exposure ourselves through our own off-benchmark investing.”

Even those wealth managers that invest in hedge funds have some concerns about their role and performance.

One concern arises, ironically, from hedge funds’ efforts, largely mandated by regulators, to improve customers’ understanding of what precisely they were doing.

“Overall, the industry has become much  more transparent,” says Pictet’s Mr Campiche. “The drawback is this has a negative impact on performance. The reason why hedge fund managers were reluctant to share information was not because they were all fraudulent, like Madoff. It was to protect their competitive edge. Once you become totally transparent, some of the edge disappears.”

This is one reason why, over the past five years, hedge fund returns have not been as high as before the credit crunch, believes Mr Campiche, although he also blames low interest rates, for reducing the returns on risky assets in general.

Investors have, in particular, been disappointed by returns in recent years for global macro strategies – the trading of a wide variety of assets based on an overall view of a few countries, a region, or the global economy.

Over the past two or three years, “the linkages between the price of different assets, which macro funds trade, have broken down,” suggests Mr Armitage of Citi. “It could be a long wait for those linkages to come back.”

Other wealth managers criticise recent poor performance of commodity trading adviser hedge funds, which attempt to make money from following market trends by using futures and options contracts.

Realistic expectations

Expectations that hedge funds can provide spectacular returns have certainly subsided, but experts emphasise that this ratcheting down of expectations to more realistic levels still leaves hedge funds attractive to private bankers, in particular given the current investment backdrop.

“In the past hedge funds offered the prospect of double digit returns, but now investors are hoping for higher single digit returns, of 7 to 9 percent,” says Amin Rajan, CEO of Create-Research, a UK-based research company. “In today’s low-yield environment, those returns look very attractive.”

Popular strategies among private clients include long-short, and mezzanine credit as a higher-yield alternative to fixed income, he adds.

Hedge funds have, therefore, survived the widespread disillusionment with their credit crunch era performance among disgruntled private clients, by carving out a new niche in these investors’ portfolios. Hedge funds have, among private bankers, lost their allure as an exciting but risky asset. They are, instead, seen as a more dependable form of investment return. In 2014 private bankers are depending on them, in particular, as a stop-gap while they wait for better yields in fixed income, and correction followed by further advances in equity markets.