Investors stick with hedge funds despite losses

By:
Helen Avery
Published on:

Performance varies widely; Clients still boosting allocations.

Hedge funds are enduring challenging times. The sector just experienced its worst monthly performance since 2008, with data from HFRI showing hedge fund aggregate returns fell 1.7% in January.

Outside the top 20, a collective $99 billion of investor money was lost last year, according to London-based fund of funds LCH Investments. 

In spite of the industry’s overall losses, Ken Heinz, president at HFRI, says it’s hard to discern if investors are concerned about hedge funds as an asset class. "Some hedge funds are up, some are down, and markets are equally volatile. It’s too soon to predict how investors will act this year," he says.

Indeed, sector returns are all over the map. The HFRI event-driven asset-weighted index was down 4.29% for January, while the macro index was up 1.67% in spite of oil price concerns. Equity hedge lost 3.51% over the month.

Among the largest and most-established managers, returns were equally disparate. Ray Dalio’s Bridgewater Associates and Israel Englander’s Millennium Management produced the largest gains for investors at $3.3 billion and $3.5 billion respectively over the year. But John Paulson lost $2.1 billion over the year, while Bill Ackman’s Pershing Square reportedly lost 16% of its assets, partly due to bad bets on Valeant Pharmaceuticals.

Anita_Nemes-160x186     
Anita Nemes, Deutsche Bank:
Investors are seeking less 
correlated diversified return
streams
Anita Nemes, managing director and global head of the hedge fund capital group at Deutsche Bank, says that the return dispersion has been one of the key observations from her firm’s annual alternative investments survey of 504 hedge fund investors. 


Respondents said top quartile returns averaged 10% last year, yet their bottom quartile managers lost 5% or more. 

That’s changing how investors are approaching the asset class

"Because of the dispersion in returns, investors are really honing in on picking the right manager and constructing the right portfolios," she says. "[They] are concentrating and redesigning their portfolios in search of less correlated, diversified return streams." 

Indeed many more investors said they would use risk premia strategies. About one-fifth of hedge fund investors already invest in alternative beta/risk premia strategies today, and 60% of these plan to grow their allocation in 2016.

Gregg Bunn, global co-head of prime finance at Deutsche Bank, says investors are looking to increase allocations to "products such as alternative beta/risk premia strategies, liquid alternatives, hybrid private equity/hedge fund vehicles and co-investment opportunities".

Rather than spreading risk over a larger number of managers, Nemes says that the opposite has happened. 

"Pre-2008, investors often had more than 100 names in their portfolios. Even several years ago that number was 60 or so. Now the average number of funds held by institutional investors is just 36." 

That number is even smaller among endowments and foundations, which have just 19 funds in their portfolio. 

As a result of this contraction, manager turnover has increased. "It’s not easy to become one of 36," says Nemes. "It is becoming increasingly competitive to find a place in investors’ portfolios." 

According to HFRI, almost 50 hedge funds closed last year. 

Multi-strategy and event-driven strategies are among those expected to face the highest turnover in 2016, according to Deutsche’s survey. Some 16% and 20% of respondents plan to redeem from these strategies respectively, while only 9% and 18% plan to add. Additionally, 18% plan to add to credit distressed and 17% plan to reduce.

After a strong year of performance, equity market neutral strategies are expected to be among the best performers in 2016 and are also the most in-demand due to the smaller number of them. On a net basis, 32% of investors are increasing their exposure to fundamental equity market neutral (versus 17% last year), and 18% to systematic equity market neutral (versus 11% last year). It could well be the year of the commodity trading adviser.

The average losses of hedge funds are not deterring investors. According to the Deutsche survey, investors expect hedge funds to outperform equity markets this year. Additionally 41% will increase their allocations to hedge funds this year, and 48% are staying with the same allocation. 

Nemes says private banks, investment consultants and pension funds are increasing their allocation the most.

Expectations for performance are high. Investors are targeting 7.49% returns from their hedge fund portfolios this year, and industry assets are expected to grow around 5% in 2016, surpassing $3 trillion.

With such high expectations, investors say they do not mind paying higher fees. In spite of the lower performance overall, management and performance fees have come down only marginally. 

According to Deutsche’s survey, the average management fee that investors pay remains unchanged year on year at 1.63%, although the average performance fee has trended downward slightly during this period from 18.03% to 17.85%. Yet almost half of investors say they would allocate to a manager with fees in excess of 'two and 20’ for a new allocation.