Hedge funds miss out on appetite for alternatives

Low interest rates and volatile equity markets have left many investors scratching their heads as to where to find sources of returns that fit in with their risk profiles. With yields at record lows, those who are mandated to have large portions of their portfolios in fixed income are finding things particularly tough.

Is this now the time for investors to start looking meaningfully at alternatives for a way in which to plug this gap? And if so, what role can hedge funds play?

“For some institutional investors, who have half of their portfolio yielding well below their required rate of return, the other half has to do extremely well to make up for that,” says Ken Heinz, president of Hedge Fund Research. “You are starting to see some investors who have not looked at alternatives a lot recently, starting to come back around and look at things like hedge funds.”

Nevertheless, hedge fund returns have hardly been stellar of late, while fees, though gradually falling, remain higher than in many other investment products. Not to mention the fact that these vehicles have yet to overcome the reputational damage they incurred following the financial crisis. 

Indeed inflows have been concentrated into Ucits funds, which appeal to institutional investors because they provide access to hedge fund strategies in a more regulated, transparent and liquid format than traditional structures. 

“In Europe the winner is Ucits and the winner takes it all,” says Eric Debonnet, head of alternative investments at BNP Paribas Capital partners.

“Having hedge funds in portfolios has almost become something of a political issue, even if they are only making up a tiny part of overall portfolios,” explains HFR’s Mr Heinz.

This year, the best performing strategies have been the event-driven ones, he explains. “We are talking about M&A, stress-decisions, activist, distressed. This is the best performing area – somewhere around 9 per cent. But this is also an area that has seen the highest amount of outflows for the year. $27bn has been redeemed.”

The months leading up to the US election saw something of an M&A boom, and this looks set to continue, believes Mr Heinz, not least because a strong dollar means US companies being more likely to buy foreign companies, rather than the other way around. Event-driven strategies should there fore continue to offer opportunities, he predicts.

At the other end of the spectrum are macro strategies, the least correlated to equity markets, which are barely up this year. “Maybe this is an area people could get into and find opportunities that haven’t been there over the last couple of years,” says Mr Heinz.

Increased demand

“We are definitely seeing demand for alternatives at the moment,” reports Patrick Ghali, managing partner and co-founder of hedge fund advisers Sussex Partners. “A lot of the private banks we are talking to have started, or are in the process of starting, big campaigns to shift client assets into alternatives.”

The low interest rate environment means there are not a lot of options as to where you can allocate your capital, he explains. Equities and fixed income are perceived to be expensive and “frothy”, and a lot of advisers do not want to give advice at this point because they have gotten it quite wrong in the past, claims Mr Ghali.

“The key is that you have to be able to show what the value proposition is and how you can generate return,” he adds. “And hedge funds seem to be one of the areas where you can allocate risk but in a managed manner – where the downside is protected. Investors are very worried that if they go long-only equity or fixed income then their downside is very vulnerable.”

Institutional investors and UHNWIs are also much more willing to invest in illiquid strategies then they have been in the past, says Mr Ghali, explaining how he has seen huge growth in this area among family offices.

JP Morgan Private Bank has remained consistent in its allocation to hedge funds. “Hedge funds provide our clients with an expanded toolkit beyond that of long-only funds which we believe will be important over the coming years,” says Robert Klein, global head of alternative investments.

In 2016, the private bank favoured less directional strategies including credit relative-value and macro hedge funds – both of which have performed well and exhibit low correlations with traditional equity and fixed income markets. “While long-short equity and event-driven strategies struggled in 2016, we expect that as markets differentiate between winners and losers, many of these strategies are well-positioned going forward.”

One bank that has seen allocations to alternatives on the up is UBS Wealth Management, currently recommending allocations of 16-20 per cent to hedge funds for most investors. In a world of low yields and an advanced economic cycle, simply owning beta is no longer a suitable investment strategy, explains James Purcell, head of ultra-high net worth cross-asset strategy at UBS Wealth Management. Investors need something a little more nuanced.

“Hedge funds are superb for that,” he says. “They can offer diversification in a portfolio, they offer drawdown protection, and they can offer an additional source of alpha, or at the very least, an alternative beta to what you would normally get.”

Hedge funds have also, somewhat unfairly, been victims of some bad press, he claims, pointing to how although some have painted a world in which people have been withdrawing from these vehicles, assets are actually at an all time high. And the damage done to their reputations post-2008 is also not fully deserved.

“It is somewhat unfair to expect an asset to be magical. Hedge funds can be very good, but they are certainly not magical.” The fact that hedge funds lost money in the financial crisis is not all that surprising, says Mr Purcell, especially given many lost money because of the implosion of the financial system. “Liquidity and credit lines and all the infrastructure around hedge funds – but which they didn’t have direct influence over – began to fall apart.”

It might sound a little boring, but the key to anyone considering allocations to hedge funds is to hold a diversified portfolio, he believes. If you take the major hedge fund styles: equity/long short, event-driven, macro trading and relative value and look at their performance this year, the worst have been the trend-followers, the CTAs, explains Mr Purcell. 

“But if you were to cut those out and just have the other three, you would have a worse risk-adjusted return this year. Different styles work at different points in the cycle, and as a consequence, that diversification is powerful.”

Now that hedge fund strategies are available within a Ucits framework, these investments have become more accessible for a huge range of clients, says Simon Fox, senior alternatives investment specialist at Aberdeen Asset Management, particularly for those who have no option but to invest in regulated vehicles. In addition, within a multi-asset concept, it makes them more accessible, because you have access to greater transparency and a daily-dealing product.

But investors have to find strategies that offer them a different pattern of returns to equities and bonds, says Mr Fox. “If you are worried about what is going to happen to traditional beta then you don’t want to be allocating to hedge funds or illiquid alternatives that have a large amount of traditional beta within them,” he explains. 

Quick thinking

Key to hedge fund performance in 2016 was the ability of funds to react to the macro environment, says Luke Newman, manager of the Henderson Gartmore UK Absolute Return Fund. He explains how flexibility was required to deal with low oil prices, the Brexit vote and the US election, as well as the inflationary pressures that been building over the last few months, which have had a huge impact on the movements of banks and financials.

“So flexibility is key and underlining that is the importance of a tactical trading book within an absolute return strategy with its ability to both preserve capital and provide absolute returns for investors.”

Going forward, he expects the volatility to continue, but that should provide opportunities on both the long and short sides of hedge fund strategies. The Henderson fund has increased its long positions within banks and other financials – business models that he believes should benefit from any inflationary pressures and rises in interest rates – while holding on to high quality, dividend paying stocks. On the short side, rising minimum wage legislation could prove perilous to certain sectors. 

“Many companies within sectors such as leisure, government outsourcing and retail, may see their margins coming under pressure, and their share prices therefore look perilous at current levels.” 

Mr Newman may highlight the importance of flexibility, but this is something that many of the really big hedge funds struggle with, claims Cayman-based Jarrod Farley, a partner at law firm Carey Olsen. 

“The top performing funds tend to be the in the $300-$500m sweet spot,” he argues. “Once you get into the billions it is very hard for them to put that capital to work in the same quick and nimble way that they used to.”

Too much money is concentrated with a few managers that have done very well in the past but have since become very institutionalised running these “monster” funds, explains Mr Farley. 

A few years ago the trend was for all of the assets to go towards the big managers, says Mr Ghali at Sussex Partners. “We always questioned the value of some of these guys. They tended to be the ones who were very institutional, very large. Performance was so-so. They were all slashing fees. Pursuing a volume strategy almost. Now in the press you are reading a lot about redemptions, and funnily enough, these tend to be coming from the same big guys that got all the money before.”

There has certainly been a trend of smaller managers outperforming the bigger funds, agrees Gilles Guerin, CEO of BNP Paribas Capital partners, but a lot of the big institutions are unable to allocate to these smaller players. 

“It can be hard for big firms to go with a smaller manager because they end up owning a big portion of the asset. And they often end up with huge positions in one fund which makes it harder to move money around.”

There has been a high dispersion over the last two or three years between returns for different hedge fund strategies, and even within strategies between different managers, he explains. “Those asset allocators that have an active manager selection and turn them over on a fairly regular basis are able to add value if they do it correctly.”

Although the low yield environment is certainly driving investors towards alternatives, it is not really hedge funds that have been the main beneficiary, he notes.

“I have to say the main beneficiaries have been real estate and private equity. Then probably infrastructure. Hedge funds have also benefitted, but to a lesser extent.”

Amin Rajan, CEO of Create Research and strategy adviser to leading banks and asset managers, agrees. “In the current phase of the market cycle, private debt, private equity, liquid alternatives and real estate are more highly favoured than hedge funds and commodities.”

The unconventional monetary policies of central banks have made it harder for hedge fund managers match their pervious track records, he explains. “Their growth has faltered lately. However, they still remain in favour, as investors seek low volatility returns.” 

VIEW FROM MORNINGSTAR: Focus on past performance sees investors struggle

As equity prices move higher, deposit rates hover near zero and bonds remain expensive, investors are increasingly struggling to find attractive investment opportunities in traditional assets. 

It is therefore unsurprising that alternative Ucits funds have been one of the most popular destinations for European investors’ capital in 2016 with €21bn ($22.2bn) flowing into funds in these categories in the first three quarters of the year.

While it has become the standard practice among investors to lump these funds together as a single group, alternative Ucits funds represent a bewildering array of strategies, demonstrated by the fact that Morningstar currently tracks 20 alternative categories across Europe. 

Despite the variety of options available to investors, we have witnessed a high degree of concentration in the alternatives space at both the strategy and fund level with almost 50 per cent of net capital flows being directed towards multi-asset absolute return funds since the beginning of 2014. 

As these funds do not sit well within a typical asset allocation template, their popularity appears driven by a focus on achieving reliable positive returns rather than gaining particular asset or strategy exposure. 

This approach can result in too great a focus on recent past performance, leading to poor outcomes for investors as they buy and sell at the wrong time. Evidence of this is provided by Morningstar’s ‘behaviour gap’ research which shows that the return of the average investor in an alternatives fund has lagged the headline return of the fund by 58 basis points per annum over the last five years. 

Several high profile and highly regarded funds have struggled to deliver positive return this year, with the most obvious example being Standard Life GARS. Other examples include JP Morgan Global Macro Opportunities and AVIVA Investors Multi Strategy Target Return. 

Currency volatility has been a key driver of returns this year, as shown by the poor performance of Henderson UK Absolute Return which has suffered from the fall in sterling.  The impact of currency was also evident in the performance of Legg Mason WA Macro Opportunities bond fund.

As investors, we can draw on three key guidelines when considering alternative funds. First, we must have a clear understanding of why we own an alternative Ucits fund. Second, having selected an appropriate fund, remain focused on the long-term. Finally, be aware of the unwanted exposures that can have a significant impact on the success of the strategy.

Dan Kemp, EMEA chief investment officer, Morningstar Investment Management