Editor’s note: The hedge fund industry is facing tough times. Financial Poise reported in September that an increasing number of America’s biggest pension funds and endowments are complaining about fees and underperformance, and Bloomberg weighed in on the same issue last week. Below, Caroline Rasmussen of the alternative investment platform iCapital Network explains why she believes investors still need to consider hedge funds.
There is no doubt this is one the toughest periods for the hedge fund industry on record. Years of historically low interest rates and frothy stock market valuations have resulted in hedge funds collectively underperforming the S&P 500 Index every year since 2008. The asset class has suffered its biggest investor redemptions this year since the aftermath of the global financial crisis, amid criticism of both lackluster returns and high fees. Performance and fees are viewed as the key drivers of change in the industry by, 44 percent and 43 percent respectively, of hedge fund managers themselves, according to a July survey by Preqin.
However, as noted by Grant Engelbart, portfolio manager at the $6 billion Omaha-based CLS Investments, “Investors want alternative investments in their portfolios, but expect them to perform well all of the time”, an expectation that is at odds with the basic premise of a diversified portfolio – that not all investments perform well in all markets. In addition, this expectation ignores the fact that hedge funds are designed to outperform during downturns.
Because hedge funds have the ability to go both long and short stocks, thereby hedging their risk, over time they have earned a return close to stocks at a risk level closer to bonds. An analysis conducted by Cliffwater, an institutional consultant, found that hedge funds exhibited about a third the volatility of stocks, while producing comparable returns. A Preqin survey of institutional investors found that almost half (46 percent) use hedge funds to dampen portfolio volatility, with 30 percent citing the mitigation of risks in other areas of their portfolio as a key objective of their hedge fund allocations. The key point to note is that most investors use hedge funds to maintain return, while reducing risk. Since May 2008, the S&P has seen both more instances of drawdown (loss) and more severe drawdowns than hedge funds, according to Preqin Hedge Fund Analyst.
Given current market conditions, investors should consider maintaining a portion of their portfolio in hedge funds to help protect against the potential bubble that has grown in equities due to the Fed’s decision to maintain historically low interest rates. California State Teachers’ Retirement System (Calstrs), one of the nation’s largest public pension plans, recently established a new asset class called “Risk Mitigating Strategies” to hedge against volatile stocks that represent more than half its $193.4 billion portfolio. The new allocation will include global macro and managed future strategies, both uncorrelated hedge fund investment strategies, and is targeted to be 9 percent of the overall portfolio.
Calstrs’ CIO Christopher Ailman noted, “We have a very large bias to growth in GDP in our portfolio. We want to hedge that. We actually want the hedge-fund strategies not for extra return. We are doing the opposite. We think that they actually can be a defensive strategy.”
In a survey recently conducted by iCapital Network of its private member network of wealthy individuals, family offices and investment advisory professionals, almost 80 percent of respondents indicated they are somewhat or very likely to invest in hedge funds over the next 12 months, suggesting that the high-net-worth community sees value in hedge funds given today’s volatile markets. Sixty-five percent of respondents maintain a target allocation to hedge funds of 10 percent or more, with 20 percent targeting an allocation of 20 percent or more.
With investors showing little patience for hedge fund underperformance relative to equity indices over recent years, the industry is struggling to justify its traditional fee structure of an annual management fee of 2 percent of assets and a performance fee of 20 percent of any gains over the fund’s previous peak value, or “high water mark.” While these fees are higher than those charged by mutual fund managers, they also help attract high-quality investment talent. As expressed by one North American family office, “we, as investors, are given the opportunity to align ourselves with some of the smartest guys in the world, who are attracted to this space due to high potential incentive fee generation.” It is also worth underscoring that if a hedge fund loses money, or makes money but not enough to surpass its high water mark, the manager is not entitled to any performance fee, thereby aligning the interests of hedge fund managers (who also usually invest their own money into their funds) with those of their investors.
Notwithstanding this, a recent survey indicated that 73 percent of institutional investors believe management fees need to fall further over the next year, and more than half said performance fees should drop. While this fee pressure is positive for investors, research shows that higher performing hedge funds often have higher fees, suggesting that fees tend to be commensurate with class of talent.
As a result, applying arbitrary fee limits could lead to sub-optimal hedge fund selection. Rather than focusing on absolute fees, investors should examine returns net of fees to ascertain how much value a particular manager is offering.
With equity and bond markets at their current levels, it makes sense to think defensively and seek low volatility sources of return that help hedge portfolio exposure to the public markets. Despite concerns about performance and fees, 80 percent of institutional investors believe that if they were to remove hedge funds from their portfolios, their overall level of risk would increase. Particularly with fees coming down, the short exposure offered by hedge funds is attractive today in the context of inflated public stock markets.
If improperly executed, hedge fund allocations can result in high fees with little value generated. Simply adding hedge funds is not enough – allocations must be managed, fund selection is critical and access to a diverse range of strategies is key. In addition, strategy risk and levels of liquidity may make some or all hedge funds not appropriate for certain investors. However, with the inclusion of high quality managers, the right mix and number of funds, and alignment of interest with respect to fees, hedge funds can make a significant contribution to a diversified portfolio.
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