If Asia's hedge fund industry is not to be overwhelmed by a tide of mediocrity, it must be scaled down to comprise only managers that can deliver true alpha and deserve a performance fee, AsianInvestor's 7th annual Southeast Asia Institutional Investment Forum heard.

Speaking on a panel debate entitled "The evolution of hedge funds in investment portfolios" at our event in Singapore, Bryan Goh, CIO at Bordier et Cie (Singapore), suggested Asia’s hedge funds market had lost its edge due to over-regulation and a plethora of average managers.

Hedge funds used to be a cottage industry, he noted, with managers marked out by their ability to generate outperformance. “That’s what they should always be. And the regulator should butt out, because right now if you’ve got a diversified portfolio of hedge funds, guess what: no returns.”

Industry veteran and the CAIA Association’s Singapore representative, Peter Douglas, noted that in limiting the ability of hedge funds to provide high returns based on high conviction, “regulators have created more risk for investors".

But Peter Ryan-Kane, head of portfolio advisory for Asia Pacific at Towers Watson, countered that hedge funds needed to evolve and re-emphasise their skills and point of differentiation in the post-QE world of investing.

Ernesto Prado, CIO and founder of hedge fund of funds manager Ayaltis, agreed, saying that the artificial boost for markets from QE was at an end “and extracting alpha is going to be more event-driven in future”. This presents the opportunity that hedge funds need to show their worth, he said.

Investors still view hedge funds as a return enhancer, to judge from responses to an audience poll at the forum. But performance risk remains a major concern, as does fees.

The panellists agreed that the best hedge fund managers – those worth paying 2% in management fees and 20% performance fees – are hard to find or out of reach. Prado said that of the thousands of hedge funds his firm tracks, perhaps 0.01% were worthy of an allocation. 

“You are chasing the expertise of the individual manager. You need to find those mini Warren Buffetts, but everywhere you go there is mediocrity,” he lamented.

Goh noted that returns were increasingly coming from beta and that investors were paying '2 and 20' for that. "So no, I don’t think hedge funds are currently giving value for money," he argued.

Still, Prado defended those managers that were still delivering. “If you managed to deliver a positive 2.5% this year, or in the third quarter of 2015, you are providing protection," he said, noting investors should be happy to pay for that kind of performance. “In fact, it’s worth 3 and 50,” he quipped.

At the same time he agreed that regulation was “tying the hands and feet of most people and throwing them in the swimming pool”.

But while industry might look challenged from the perspective of returns and fees, Ryan-Kane suggested that hedge funds were nonetheless attractive to many of the institutional clients he deals with. "The idea [of hedge funds] has by no means run its course, in that most clients have only just begun using them,” he observed.

“We are seeing a lot of migration from clients who were passive wanting to move to something a little more active and with managers who are not traditional managers, and from public to private markets as investors become dissatisfied with listed investments."

But he acknowledged the reality that clients build strategic asset allocation in equity and bond buckets, so unless the industry could convince them to extend those, hedge funds would only ever be a small part of their allocation.

Prado agreed that without a change of attitude, hedge funds would remain of marginal influence in portfolios. Given the conservative nature and strict due diligence guidelines of institutions in the region, they would not be allowed to allocate to niche managers in the first place, however talented.

"Nowadays the Buffetts of this world are very institutionalised, highly research-led and with huge resources. That is a framework that most clients are happy with," reflected Ryan-Kane.

"An institutional wrapper, with appropriate due diligence, may eliminate the 40% return manager, but not the one who will return 5% to 10% on a regular basis. I’d settle for something that is systematically demonstrable, allied to some element of skill."

He added the myth that hedge fund managers would always outperform needed to be addressed. "Managers need to speak the truth and say there are times when their strategy won’t work," he said.