Heightened volatility in public markets due to the geopolitical and macroeconomic uncertainty of recent years has spurred a resurgence of institutional investor interest in hedge fund allocations, according to investment experts.
“We've seen more investors looking into hedge funds, in search of alpha generation opportunities and public market-uncorrelated returns with reduced volatility,” Gary Leung, head of alternatives for APAC clients at J.P. Morgan Asset Management, told AsianInvestor.
“That said, for institutional investors such as sovereign funds, hedge funds have always been their staple allocation, so they're only looking to adjust and selectively increase their allocation.”
Some insurer such as Singlife have also previously told AsianInvestor that 2023 could be a good year for hedge funds.
Hedge funds have the flexibility to invest in different parts of capital markets, allowing investors to adopt diverse strategies and capture different return streams to which they may not have direct access, Leung said.
“Hedge funds are typically not compared to traditional market benchmarks. Some of them thrive not only during market dislocations but are able to generate alpha in docile market conditions,” he said.
HEDGE FUNDS VS EQUITIES
With traditional 60/40 stock-bond portfolios down 16%, and the MSCI AC World Index down 18% last year, investors have had very few safe havens, Leung said.
The HFRI Fund Weighted Composite Index, a global, equally-weighted index of the largest hedge funds that report to the HFR Database, declined only 2.8% last year.
“Hedge funds can help investors maintain their exposure to public markets with reduced drawdowns, and can also achieve attractive returns with lower volatility, making them compelling to institutional investors that look for stable, risk-adjusted returns while avoiding headline risks,” he said.
From 2013 to 2022, the MSCI AC World Index had an annualised return of 8.5%. but came with annualised volatility of 15.5%.
Meanwhile, in the same period, the HFRI Fund Weighted Composite Index achieved an annualised return of 4.9%, but with much reduced volatility of 5.6%, or approximately one-third of the volatility of global equities.
Although hedge funds can generate outperformance at lower volatility levels than public market assets, they do not behave like a uniform asset class, according to Eric Chng, head of alternatives solutions for Asia-Pacific at State Street.
“When you break down hedge funds by strategy, they're actually very different. Selection skill is key to a successful investment programme,” Chng told AsianInvestor.
Hedge funds' presence in public markets tends to be in equities, bonds, futures and options, alongside their holdings of private assets. However, managers of these funds also have the flexibility to reallocate and move with sudden volatility in markets, Chng said.
“Over the last three years, there have been a series of black swan events and geopolitical tensions which have led to unexpected and very sharp corrections in asset prices, and a sharp spike in the commodity side of the business,” he said.
“Managers within a hedge fund segment have the ability to seize those trends and capitalise on them, and therefore they're able to capture alpha. They can rapidly deploy their capital across a macro environment through a different instrument class,” Chng said.
As hedge fund performance can vary widely, manager selection is critical. The discrepancy between the top and bottom quartile of managers has been as wide as 14% annually over the last 10 years, according to the HFRI Fund Weighted Composite Index.
The global economic environment remains uncertain, and institutional investors should strongly consider adding a layer of portfolio diversification via a hedge fund, according to Paul Colwell, senior director of investments and head of portfolio advisory for Asia at WTW.
“I would encourage institutional investors that don't have an allocation to consider a strategic allocation or a longer-term allocation to have in place and ready for whenever the next period of volatility or the next crisis arrives. That gives you this kind of diversification benefit,” Colwell told AsianInvestor.
“Elevated volatility is going to be a feature of the economy and the outlook for the next few years, no doubt. Monetary policy, inflation, geopolitics – you can count a list of various kinds of things that can impact on markets. Having the ability to be able to generate a return in a way that's not tied directly to the economy, or to equity and credit markets, is valuable,” he said.
Colwell has observed increased interest in hedge fund allocations among WTW’s institutional clients, but says the complicated nature of such investment vehicles often causes much hesitation among investors, which he says is justifiable.
Although hedge funds can be a source of outperformance, they are often very complicated and difficult for stakeholders to get their heads around, and some use derivatives and potentially high degrees of leverage. Some fail completely and blow up, Colwell said.
“You need to really be very careful in managing which hedge funds you allocate to, and build a diversified portfolio, making sure that the risk is well managed and you don’t have too much in any single strategy,” he said.
“You do need a diversified portfolio. You don't want to be investing in in a hedge fund that blows up and takes down your entire allocation's performance – because it can happen.”