Though just five percent (or 400) of 8,000 hedge funds (HFs) are even considered investable, according to Joe Marenda, a managing director and hedge fund specialist at Cambridge Associates, “the beauty [of hedge funds] is really in the eye of the beholder—based on portfolio need,” he said. Though institutional investors are currently holding their allocations to hedge funds flat, at best; at worst they’re exiting the class, according to a recent report from EY. Investors that spoke with IA last week largely substantiated Marenda’s “beauty in the eye” explanation regarding their approach to the class.
The hedge fund industry has changed markedly since 2004—it’s much harder now for managers to source alpha, and the economics (what allocators should pay and what hedge funds should earn) are challenging for both investors and for the hedge funds, said Elizabeth Burton, CIO of the $16.8 billion Hawaii Employees’ Retirement System.
Burton does not view hedge funds as past their time. Nor does Craig Husting, CIO of the $44.5 billion Public School & Education Employee Retirement Systems of Missouri. “I don’t think the days of hedge funds have passed,” he told IA. “We think the right hedge funds continue to have the opportunity to offer consistent alpha. Additionally, hedge funds can bring needed diversification to a portfolio. We believe the economics with hedge funds have improved in the favor of the investor.”
Niche strategies are the safest way to approach hedge fund investment, stated Susan Slocum, CIO at the $750 million Children’s Hospitals of Minnesota. “We are looking at hedge funds again, using very specific, narrow strategies,” she said. “Returns dropped significantly over the last five to seven years, plus the equity markets have been a better place to have money, until October occurred,” she explained. Pinpointing good hedge fund managers is difficult for several reasons, she said, including limited transparency into hedge fund managers’ positions. “And fees are high—it used to be 2% and 20% of profits but many now ask 1% and 20%. But with so much press about mega rich hedge fund managers it’s difficult for an investor to have gotten 3% to 4% returns and then read about how many yachts their hedge fund manager has in the Mediterranean,” she said.
It can be difficult for investors to retain the alpha that was generated from a hedge fund investment due to high fees, agreed Christopher White, a portfolio manager for special opportunities investments within the Teacher Retirement System of Texas. “What is considered investable for us is a much higher bar than the typical investor—a hedge fund needs not only to be of institutional quality, but must have the capacity to invest large amounts of capital,” he said. “The hedge fund industry is not delivering the same returns it once did, thus there is pressure on hedge funds to produce more opportunistic products and drawdown structures,” he added.
Two Funds Lower Allocations to HFs
The $8.3 billion Employees’ Retirement System of Rhode Island opted to eliminate most of its hedge fund investments in 2016 when it adjusted its strategic asset allocation, according to Evan England, communications director for Rhode Island General Treasurer Seth Magaziner. “We redeemed about $600 million from hedge funds, reducing our target allocation from 15% to 7%,” he said.
He explained that the performance of many hedge funds did not justify the cost at that time. “We also decided to increase our allocation to private equity, which has consistently outperformed even after expenses over the course of five years. We found that hedge funds were the only asset class where, in the previous three years, more money had stayed with the manager in the form of fees and expenses than had been returned to the fund as performance. We made this change after thorough analysis of our entire portfolio and adopted a strategic asset allocation designed to provide long-term growth and stability.”
“We [now] have five funds in our Opportunistic portfolio, where there used to be a few dozen,” said Anthony Chiu, director of alternative investments at the $17.6 billion Kentucky Retirement Systems. “KRS originally invested with funds-of-funds several years ago, but all of that has been redeemed. Today we’re looking on an opportunity-by-opportunity basis. This portfolio has an 0%-10% allocation range, so it doesn’t have to be filled if we don’t find anything that meets our hurdle,” he said. “We have board members with alternative investment experience that have been instrumental in helping us set the direction of the portfolio. But it’s always going to be hard to figure out who to work with and the right structure—that never changes.”
Hedge funds were the only asset class where more money had stayed with the manager in the form of fees and expenses than had been returned to the fund as performance.
Continuing a multiyear trend, the vast majority of investors expect to keep their allocations to hedge funds flat, according to an EY survey released last week titled 2018 Global Fund Alterative (IA, 11/8). By a ratio of three to one, investors that indicated they expect changes to their hedge fund allocations forecast decreases rather than increases, the report stated. The hedge fund industry’s continued lackluster performance relative to perceived high costs, combined with hedge funds already comprising a large percentage of investors’ existing portfolios is a leading concern for many, the report continued.
The largest HF managers, those with more than $10 billion in assets under management, were attracting the most capital as they leveraged their broad and diverse product offerings to raise funds, the report noted. “Many midsize and smaller managers are playing a zero-sum game among each other, resulting in some managers winning at the expense of others,” the report concluded.
It’s always going to be hard to figure out who to work with.
Consultants Weigh In
While there are smart, skilled hedge fund managers out there, they are hard to find; additionally, the hedge fund industry has been historically burdened by a high-cost basis—often, alpha is overridden by fees, said Todor Todorov, a member of the manager research team focusing on diversifying strategies at Willis Towers Watson. “Long-term, hedge funds falling behind is not an issue; we encourage our clients to think more about portfolio diversification.”
Public funds typically employ modest allocations to hedge funds, Eileen Neill, managing director and senior consultant at Verus told IA. “It’s rare to see more than a 10% allocation to hedge funds,” she added. “There was a time when public funds, en masse, threw a lot of money to hedge funds, investing without understanding the true risk exposures. When they exited during the global financial crisis, various hedge fund shops shut down.”
Verus has partnered with boutique hedge fund consultant Aksia to provide its institutional clients a robust resource to identify the top HFs, Neill noted.
An institution’s interest in hedge funds could vary considerably, based on whether it is an opened or closed pension fund and its funded status, or whether it is an endowment or foundation, which typically has an infinite life. Each institution has a unique risk tolerance and the size of the allocation to hedge funds, the types of strategies employed, and individual funds chosen should be customized to the institution’s needs, according to Cambridge Associates’ Marenda. “For instance, a well-funded pension plan or a closed pension plan is particularly sensitive to drawdown risk, which likely drives its total allocation to hedge funds and the types of strategies and managers chosen,” he said.