Under pressure to justify their hedge fund programmes, investors are cutting the number of hedge strategies they allocate to and negotiating lower fees, finds a global survey* by Deutsche Bank.

This follows several years of underperformance by hedge funds overall and comes amid growing divergence of industry returns.

The average survey respondent now allocates to 33 hedge funds, down from 42 three years ago, meaning competition is getting even fiercer for the best performers.

Erin Wu, head of investor relations at Hong Kong-based OP Investment Management, said a big US family office had recently reduced the number of the hedge funds in its portfolio from 30-odd to about 25 in the past year.

“Due to the unsatisfactory performance of hedge funds in 2016, some allocators have withdrawn from some of the hedge funds they invested in,” she told AsianInvestor.

Erin Wu

Investors were targeting a return of +7.23% in 2016 for their hedge fund portfolios, yet they had in fact received just 2.99% as of November 30, according to the Deutsche Bank survey. In 2015 they had targeted +7.45% and received +3%.

Yet they remain optimistic, targeting an average target return for this year of +7.52%.

As global policymakers diverge in their approach to spur economic growth, many investors believe the resultant risk asset decoupling and price instability will provide opportunities for hedge funds in the year ahead, said the report.

The Deutsche Bank survey pointed to other reasons why institutional investors were consolidating their hedge fund portfolios. These included a lack of resources to monitor a large number of managers and a belief that over-diversification can negatively impact portfolios, given the vast performance divergence in the industry.

On average, investors’ top-quartile funds returned +11.22% for 2016 (+10.97% in 2015), while respondents’ bottom-quartile managers were down -6.86% in the year (-2.86% in 2015).

Fee negotiation

Still, by consolidating their hedge fund portfolios, asset owners can leverage their larger ticket sizes in fee negotiations and thus reduce costs, noted the report.

Indeed, the topic of fees has moved to the forefront of investors’ minds and is playing a critical role in allocation decisions. Around half (52%) of survey respondents said a manager’s willingness to negotiate on fund terms was a key factor – alongside performance – in their decision to invest.

Robert Mullane, managing director in the alternative investments and manager selection group at Goldman Sachs Asset Management, agreed that fee discussions were becoming more important in discussions over hedge fund allocations.

Respondents to the Deutsche survey said the average management fee they paid for hedge fund investments was 1.59%, down from 1.63% last year. Institutional investors are paying on average 1.51% (versus 1.59% last year).

The average performance fee has also fallen, to 17.69% from 17.85% year year-on-year. Institutional investors are paying on average 17.52% (versus 17.73% last year).

Nevertheless, 40% of investors would still make a new allocation to a manager with a 2% management fee and 20% performance fee. Pension funds are the least willing to invest in managers with such fees, with only 26% of this segment able to consider such fee arrangements, the survey showed.

Looking ahead

In the coming year, private banks and wealth managers look set to be the most likely drivers of hedge fund flows in 2017, as they were last year.

Two-thirds of respondents are looking to increase their alternatives allocation in 2017, compared to 58% last year. Of course, that includes private market strategies, such as private equity and real estate, as well as hedge funds.

In 2017, 31% of all institutional investors are planning to add to their alternatives allocation and 52% to maintain the same exposure.

This comes after half (52%) of private banks and wealth managers increased their hedge fund allocation last year, while 28% kept it at the same level. Meanwhile, one-fifth of institutional investors increased their hedge fund allocation in 2016, while 56% kept it the same. 

In terms of strategy, discretionary macro is the most sought after strategy this year. On a net basis, 27% of respondents plan to raise exposure in this area over the next 12 months. Discretionary macro came second in terms of popularity last year, behind fundamental equity market neutral.

Furthermore, investor appetite for quant macro has also increased significantly year-on-year, moving up to third from 12th last year (with a net 15% planning to add exposure).

Deutsche Bank Wealth Management is looking for macro managers and long/short equity funds to add to its recommended product list, said Joyce Ngan, Asia-Pacific head of fund solutions, earlier this year. 

However, for the first time in five years, fundamental equity long/short has dropped out of the five most popular strategies. While 22% of respondents are planning to increase such allocations over the next 12 months, 18% plan to reduce them.

* The survey received responses from 460 global hedge fund allocators, which collectively manage and/or advise on $1.9 trillion of hedge fund assets, representing two-thirds of the industry’s AUM, which was $3.02 trillion at the end of 2016.