Investors
Just 38% of institutional investors are satisfied with their hedge fund returns, compared with 62% in 2011, as the industry continues to grapple with underperformance, according to an investor survey by SEI.
This dissatisfaction comes following several years of poor hedge fund returns. In 2011, managers lost 5% on average, although they recovered in 2012 posting gains of 6.2%, and the signs have so far been positive for 2013. However, hedge funds have lagged behind the S&P 500 and other market benchmarks and this, said Ross Ellis, vice president and managing director of the SEI Knowledge Partnership for SEI’s Investment Manager Services division, explained the negative sentiment.
“Long-only returns have improved markedly in 2013 with the FTSE and S&P up 9% to 10% year-to-date yet hedge funds are having a hard time generating decent returns in this low interest rate environment, as evidenced by the HFRI being up by half as much. However, it is advised that investors do not benchmark hedge funds against certain long-only indices as it is important to remember that many hedge fund managers provide downside protection and non-correlation to investors, and therefore investors should reach some compromise and recognise they will not always garner 100% of the upside,” said Ellis.
A majority of investors (70%) also told the SEI study that there “are too many lookalike strategies in the hedge fund industry today. “It is not enough for hedge funds to distinguish themselves in terms of their pedigree, talent, strategies and performance. They must also articulate their investment process and explain what makes their results repeatable,” read the SEI study.
It is unsurprising in this environment that hedge funds are being forced to make concessions to investors, particularly with fees, a point also made in the SEI study. In fact, J.P. Morgan’s Capital Introductions Group said in 2012 that allocators had successfully reduced management and performance fees 42% and 26% of the time respectively at hedge funds. “Investors are looking at the 2% management and 20% performance fees managers are charging and asking ‘where is the value?’ There is significant pressure on hedge fund fees, particularly in this lower performing market environment and only a few of the super star managers can nowadays charge very high fees,” said Ellis.
Despite malaise about performance, investors are still willing to allocate to hedge funds, said SEI. Surveys conducted by the prime brokerage businesses of Deutsche Bank and Credit Suisse earlier this year predicted hedge fund AuM will grow by 11% and 10% respectively in 2013 bringing industry AuM to $2.5 trillion, a new record. “Investors, at the end of the day, need to make - for example - 7.5% to 8% annual returns and they cannot get that in fixed income, and up until this year they could not get those returns in long-only either. That left hedge funds and private equity as the only viable alternatives. There are good hedge funds out there and investors will write them cheques,” said Ellis.
Many have also argued that the growing institutionalisation of hedge funds has been detrimental for returns. Some highlighted risk- averse investors, such as pension funds, are loathe to allow managers to take excessive risk, which can ultimately stifle performance. “The golden days of hedge funds have passed, and risk management is now the absolute priority for investors. Institutions are no longer buying the fund and the manager but rather the firm, and that includes the robustness of operational infrastructure and significant risk controls. Our survey showed that performance and fees were not even in the top five investment criteria for allocators whereas risk management was number two,” said Ellis.
Inherent investor conservatism has facilitated a flight to size, as the largest managers continue to hoover up the majority of assets, the SEI survey added. A 2011 report by Hedge Fund Research confirmed so much estimating three quarters of net capital inflows that year went to managers running more than $5 billion. This is despite small hedge fund managers consistently generating better returns than their larger counterparts with a PerTrac study – Impact of Size and Age on Hedge Fund Performance 1996-2011 – acknowledging nimble managers had outperformed large managers in 13 out of the last 16 years.
Ellis highlighted there was a rationale behind large investors’ aversion to smaller managers. “If large institutional investors like CalPERS or ADIA, with hundreds of billions of dollars to invest, are going to make an allocation, it will be in the tens or even hundreds of millions of dollars mark. If CalPERS invests $10 million into a $50 million hedge fund, that is 20% of the manager’s assets, and if that manager delivers 30% returns, the material impact on CalPERS’ total portfolio would be minimal,” he said.
Nonetheless, smaller managers are still attracting money from funds of funds and high net worth individuals returning once again to hedge fund investing. “There is demand for small managers from investors, particularly via funds of funds, which are making emerging managers a key part of their value proposition to clients,” he commented.
The SEI study also said funds of funds were continuing to struggle, having still yet to recover from 2008. Hedge Fund Research data put funds of funds’ AuM at $638 billion in 2012, a far cry from the 2007 peak of $798 billion. SEI’s poll of investors revealed three quarters invested in single managers directly, up from 40% in 2011 and 24% in 2010. Nonetheless, a survey in 2012, also by SEI, revealed 84% of investors believed funds of funds, as an asset class, would exist in 20 years time, while 72% acknowledged these businesses still played a valuable role in institutional investment portfolios.
However, funds of funds’ survival are not guaranteed. SEI said the asset class needed to customise portfolios, focus on emerging managers and niche strategies, enforce proactive risk management, adopt more portfolio concentration and specialisation, create managed accounts, offer consultancy services and lower fees. “Investors will not put money into funds of funds if they have to continue to pay 1 and 10 on top of the 2 and 20 if the returns are not there. But funds of funds do still serve a purpose for investors who do not have the staff or resources to carry out research on hedge fund selection,” said Ellis.
The SEI study acknowledged interest in regulated or 40 Act, mutual-fund style hedge funds was also on the up as managers sought to expand their distribution channels . This growth is evidenced on Morningstar’s “alternative” database, which stated there were 317 SEC-registered mutual funds running $140 billion at year-end 2012.There is debate about whether these regulated products will penetrate the institutional market, although one in four investors told SEI regulated products would form a part of their hedge fund allocations. Many cited improved liquidity, transparency, low cost and better regulatory oversight were the main selling points.
Several alternative managers launched products wrapped in 40 Act structures in 2012 including Blackstone, KKR, Grosvenor Partners and Permal Asset Management. These regulated entities are likely to target pension funds, high net worth individuals and retail investors via brokerage platforms.
“Many brokerage houses, platforms and financial advisors want to access alternatives via regulated products. These regulated funds are considerably cheaper than the 2 and 20 charged by private hedge funds and some are even offering investors access to esoteric products such as bank debt, for example, although they clearly have to abide by 40 Act constraints. The increased regulation of hedge funds has ironically reduced the disincentive for private fund managers to launch regulated alternatives mutual funds. I also believe the JOBS Act, which will ease marketing and advertising restrictions for private funds, will also help educate the public and facilitate the success of liquid alternatives funds. However, Ucits are more of a European phenomenon and are unlikely to take off in the US,” said Ellis.
Despite Ellis’ optimism, just 11% of large, $5 billion plus investors said they would put cash to work at regulated products with the majority preferring to opt for LPs and managed accounts. Sceptics point out 40 Act Funds are likely to follow the fate of 130/30 funds. 130/30 funds proliferated just before the crisis and some argue their failure was attributable to the adverse market conditions they were operating in. Others pointed out they were just marketing tools and the managers running them lacked the short-selling skills required to make them work.
Interestingly, funds of funds appear to be the biggest enthusiasts for regulated products despite many making exposure to emerging, niche or esoteric hedge fund strategies an integral part of their marketing spiel. “There is clearly a demand by investors for funds of funds to be looking at regulated products otherwise they would not be doing it,” said Ellis.
SEI polled 107 institutions for this survey.
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