HNWIs wading into hedge funds amid rising volatility

Wealthy investors in Asia are becoming increasingly interested in investing in hedge funds, an asset class they had mostly shunned in recent years over concerns of high fees and poor returns, say wealth managers and industry observers.

Fund selectors at private banks say that rising expectations of heightened market volatility had led some investors to seek out hedge funds—and other alternatives. This is not solely to generate relatively higher yields but also diversify and protect their investments.

This correlates with the investment aim of classic hedge funds, which traditionally aim to use the skill of highly active managers to deliver positive returns irrespective of the market's direction. However, the funds also typically have a strong focus on capital preservation.

However, the good returns generated by hedge funds in 2017 is also encouraging wholesale distributors such as private banks and wealth managers to discuss hedge fund investing with their clients, according to an investment adviser.

The HFRI Fund Weighted Composite Index, which acts as a benchmark for global hedge fund performance, gained 8.5% in 2017. That marked its best calendar year since 2013, according to Hedge Fund Research.

“There has been a real revival in investor interest in hedge funds over the past nine to 12 months—and the trend is accelerating,” Adam Proctor, market manager for Singapore, Australia and New Zealand and head of managed investments at Citi Private Bank, told AsianInvestor.

He noted that investors have primarily been interested in long-short strategies, which experts consider to be the most liquid strategy in the hedge fund universe. Their interest in this strategy is a combination the potential to enhance returns and also diversify their investing strategies. Long-short equities hedge funds gained 12.3% at the end of the year, and were the best performing strategy in 2017, according to Eurekahedge.

Investors have been quick to take advantage of this. According to Eurekahedge, global assets under management for long-short equities fund managers grew by $93 billion in 2017 on the back of strong performance gains. Total assets under management of the global hedge fund industry stood at $2.49 trillion.

Proctor said there was an even greater upsurge in interest among Citi’s private bank clients last month. They invested more in hedge funds during January than in all of 2017, although he admitted that this total was not very high.

“It’s a big change from 2015 and 2016 when there was very low appetite for hedge funds,” the Singapore-based executive said.

PORTFOLIO ALLOCATION IMPACT

High fees, high profile insider trading charges against some funds, a spate of liquidations and ho-hum returns have battered the reputation of hedge funds in recent years. 

The HFRI Fund Weighted Composite Index gained 3.3% in 2014, dropped 1% in 2015 and added 5.5% in 2016. The rise of benchmark-hugging passive instruments exchange-traded funds, many of which have outperformed hedge funds have also posed a stiff challenge.

At the end of January 2018, assets invested in passive instruments totalled $5 trillion, according to data provider ETFGI, much higher than the AUM of the global hedge fund industry.

Despite this troubled history, Janet Li, wealth business leader for Asia at consultancy Mercer, believes hedge funds still play a worthwhile role in investor portfolios.

“With greater markets risks than before, investors can consider hedge funds as part of a diversified portfolio,” she told AsianInvestor. “Investing in hedge funds doesn’t guarantee the best returns but it almost guarantees better [pre-fee] risk-adjusted returns.” 

Neverthless, she noted that hedge funds still rank behind private equity and private debt when it comes to the level of interest among wealth investors.

A 2015 report on the role of hedge funds in investment strategy by consultancy Aon Hewitt showed the addition of a 20% allocation to hedge funds in a traditional equity and bond portfolio could greatly reduce the volatility of an investor’s portfolio without having a meaningfully negative impact on returns—even once hedge fund fees are considered. The study looked at risk (or volatility) and return data for the 10 years to June 2015.

Most wealth managers AsianInvestor has spoken to in the past have said they recommend investors to allocate up to 15% of their portfolios to alternatives, including hedge funds.

VOLATILITY GAINS

With market volatility picking up, the test will be to see if hedge funds truly can protect portfolios from steep losses.

In early February, the S&P 500 lost more than $1 trillion in market value as fears about inflationary pressures and faster-than-expected interest rate hikes gripped investors. 

Mohammad Hassan, Singapore-based head analyst at Eurekahedge believes hedge funds are likely to prove their worth: “Even after a volatile February, the average global hedge fund will outperform underlying markets and deliver the characteristic downside protection,” he told AsianInvestor.

But there could be some exceptions. Short volatility strategy funds, or funds that bet volatility will stay low in markets, for instance, are likely to lose heavily after February’s market rout, noted Hassan.

“Even at the end of January, when volatility had just started to spike higher, short volatility strategies lost an average of 3.05% over the month—their steepest loss since August 2015, when Chinese equity markets crashed,” he said.

Expect February data (to be released at the end of the month) to show a much worse performance: Short volatility hedge fund strategies will likely see major losses over the month, said Hassan, adding that he wouldn’t be surprised if a few short volatility funds shut down in the next few months.

This performance contrasts greatly with 2017, when short volatility strategies pocketed 9.21% in returns, according to Eurekahedge data.

MANAGER SELECTION

Many experts believe 2018 will continue to see more bouts of volatiity as the normalisation of monetary policy by the US continues—which should enhance the appeal of hedge funds for investors.

But, as always, manager selection remains key.

Hassan noted that apart from long-short strategies, both commodity trading advisor (CTA) or managed futures hedge funds often offer uncorrelated returns compared to both traditional markets and other hedge fund strategies.

“In 2008, the average CTA was up 19.4%, while equity long-short strategies were down 19.1% [and] the S&P 500 lost 36.5%,” he pointed out.

A CTA fund uses futures contracts to run different strategies across commodities, equities and currencies.

Another factor raisign Asian investor interest in hedge funds are the generally falling fees across the hedge fund industry. The funds once tended to charge a ‘2 and 20’ model, in which they required 2% of assets under management and 20% of any positive performance, these fees have dropped oer the past decade.

Hedge funds charged 17.97% on average in 2007 but this dropped to 15.27% last year, according to Eurekahedge. Their management fees have also dropped from 1.63% to 1.22% over the same period, it said.

Even global institutional investors plan to increase their allocation to hedge funds this year, according to a survey by BlackRock released on January 18.