There’s a tangible air of optimism among hedge fund managers this year. Despite 2014’s returns being their lowest since 2011, 60 per cent of managers believe that the 2015 Preqin All-Strategies Hedge Fund Benchmark will surpass last year, which delivered a rather tepid +3.78 per cent (net).
On top of this, 80 per cent of managers expect overall hedge fund AUM to increase according to the February edition of Preqin’s Hedge Fund Spotlight report.
“More investors are getting switched on by the benefits that hedge funds can offer as opposed to getting switched off. We are largely positive on our outlook for the industry this year,” comments Amy Bensted, Head of Hedge Fund Products at Preqin.
Part of the reason for this is that institutions are cognisant of the fact that the markets have gone through somewhat of a golden period over the last five years; a period of extraordinary central bank intervention which has led to the S&P index doubling in size and bond yields to fall to near zero levels, boosting the coffers of investors’ traditional portfolios.
But this is not an endless free lunch. Equity markets are getting toppish and bond yields will start to rise as the Fed begins to slowly raise interest rates. With that in mind, investors are likely to continue allocating to hedge funds, as much by virtue as necessity, as they look to hedge their long-only exposure. That is why, despite the decision by CalPERs and PFZW to exit stage left, most institutions will keep the faith with hedge funds in 2015.
As for why managers are feeling so bullish, this is largely down to the emergence of a number of diversifying themes; falling oil prices, the ECB asset buyback programme, global economies growing at different speeds with the US leading the charge, and a fall in asset class correlations are suddenly presenting managers with more opportunities to generate alpha than in recent times.
“I would agree with that. We see quite a lot of excitement among fund managers in terms of the opportunity set that is emerging to perform well both on the long and short side. I think that’s why managers are feeling more confident on delivering stronger returns. It is good for hedge funds. It has been a difficult few years for the asset class,” says Bensted.
The Spotlight report reveals that 26 per cent of investors are planning to increase their allocation to hedge funds in 2015, whilst 58 per cent intend to maintain their current allocation. This should be good news for managers, and supports the view of Deutsche Bank who, in its 13th annual Alternative Investment Survey, forecasts that global hedge fund assets are set to surpass USD3tn by year-end and grow a further 7 per cent.
The report writes: “Institutional investment in hedge funds is set to increase, with 39 per cent of these investors planning to increase their allocation to hedge funds in 2015.”
“We do expect to see more global public pension fund money flowing in to the industry,” says Bensted. “Both managers and investors that we spoke to when producing the report didn’t think the CalPERS decision would lead to large-scale outflows. We think it’s going to be the opposite, with more money coming in.”
According to the Spotlight report, there seems to be cross-party agreement among fund managers and investors on which strategies will likely come out on top in 2015.
From the managers’ perspective, 24 per cent favour macro strategy performance, followed by 23 per cent for equity strategies and 18 per cent for event-driven strategies. As for investors, 49 per cent favour equity long/short strategies, followed by 27 per cent for macro and 22 per cent for event-driven strategies.
“It does suggests that investors have become more savvy in their understanding of strategies over the last few years. There is quite a lot of alignment in regards to where they see the best opportunities in 2015. Anecdotally, when we talk to investors the US is definitely a key focus for them at the moment,” explains Bensted.
On the flip side, those strategies that are less likely to perform are credit (according to 30 per cent of managers), equity strategies (18 per cent) and macro (14 per cent). With respect to credit, this is quite a surprising result given that it was the best performing strategy last year, returning +5.59 per cent.
As opposed to be outright pessimistic, what is more likely is that managers simply view greater opportunities on the equity and macro side in terms of market dynamics. There are plenty of excellent credit long/short hedge funds, especially those focussing more on the distressed end of the spectrum in Europe.
“What is perhaps revealing is that a similar number of hedge fund consultants are recommending exposure to credit strategies to those who are not; there is a bit of a polarised outlook on credit,” notes Bensted.
Indeed, 32 per cent of hedge fund consultants surveyed by Preqin are more bullish on credit strategies in 2015, compared to 26 per cent who are less so.
Despite all the optimism, there should be no illusions that 2015 is an important year for the hedge funds industry. The ripple effect of CalPERs is still being felt. Moreover, the fact that the Dutch pension fund PFZW announced in January that it too was divesting its hedge fund portfolio shows that investors, globally, are trying to ascertain whether they really are getting the value they need from hedge funds.
“I don’t think it’s all doom and gloom for hedge funds. Fund managers perhaps need to step up the level of dialogue with investors to explain the value that hedge funds can offer them – the ability to offer long-term risk-adjusted returns is perhaps not a strong enough message getting out to the market at the moment. There is still a degree of negative PR associated with hedge funds, even though things have improved markedly in recent times.
“Fees are still an issue. Investors remain very fee sensitive. It eats into their returns when returns aren’t great, as was the case last year. They need managers to be a bit more flexible or justify the reasons why they are continuing to use a 2/20 or 1.5/15 fee structure,” states Bensted.
The fee issue is a perennial one. And it is only going to intensify as liquid alternatives, with their lower fees and greater liquidity, curry favour with investors.
Moreover, the fact that investors are getting more transparency on their hedge fund investments is in many respects a double-edged sword for managers: on the one hand they can demonstrate to investors how they are managing risk etc. On the other hand, it enables investors to determine how much of the manager’s performance is market beta. This is not, after all, what they are paying fees for.
Management fees (68 per cent) and performance fees (38 per cent) are the two areas where investors most want to see further improvements in 2015.
“Most of the time, fee pressures are intrinsically linked to performance. CalPERS were paying a lot of fees and didn’t feel they were getting enough value from their investments. Maybe this event last year will actually help focus the discussion between investors and managers in 2015.
“That said it should be noted that there has been a gradual reduction in management fee over the last few years. Some investors hold more sway than others and are more likely to negotiate down the fees they pay,” comments Bensted.
The management fee is a tricky issue to resolve. Family offices, for example, are more inclined to understand the importance of not squeezing emerging managers too much as they work to grow their AUM and track record. For these managers, it is vital that they have a long enough runway to build the business and bed in their strategy, without worrying whether they can cover all the operating expenses.
It is therefore more likely that the management fee issue is something that investors are concerned over in respect to larger, more established managers with significant AUM.
“On the emerging side, there is recognition that there has to be a fee arrangement that is mutually beneficial; perhaps it’s locking investors in for a longer period of time in exchange for a lower fee,” suggests Bensted.
One strategy that has done particularly well in recent times, and which certainly relies on a close alignment of interests (from a fee perspective) is Activist hedge funds. Over a three-year period this strategy has returned 9.52 per cent (annualised) compared to the broader market (7.80 per cent), delivering 5.52 per cent in 2014 compared to market returns of 3.76 per cent.
Given that these are essentially quasi-private equity strategies that demand a more long-term holding strategy among investors, it makes perfect sense to adjust management and performance fees in return for locked-up capital.
“There are only certain types of investors who have an interest in more illiquid hedge fund strategies like activist hedge funds,” adds Bensted.
There have been some concerns that there could be crowding in this space leading to a dampening of returns as funds get bigger and/or new funds launch. It’ll be interesting to see how this strategy develops over 2015.
