Market views: How will hedge funds survive the cycle?

Four investment specialists tell AsianInvestor which hedge fund strategies investors are most clamouring for, and which they are shunning in today’s late-cycle environment.
Market views: How will hedge funds survive the cycle?

Institutional investors have been showing hedge funds little mercy amid disappointing returns and criticism over high fees.

Jeffrey Vinik – who previously ran Fidelity’s Magellan fund – shut down the hedge fund he relaunched earlier this year due to a tepid reception from investors. “It has been much harder to raise money over the last several months than I anticipated,” Vinik said in a letter to investors dated October 23.

While Vinik’s funds, set to be closed on November 15, generated a net return of 4.8% between March 1 and the end of September, the subpar performance of hedge funds has plagued the asset class more generally.

All but one of Eurekahedge indices posted negative gains last year. Their performance so far this year has been better but all posted negative returns in August, the hedge fund database shows, illustrating how volatile these assets can be.

Typically classified as 'liquid' alternatives, question marks are also being raised over their capacity to withstand redemption shocks.

A case in point is South Korea's biggest hedge fund, Lime Asset Management, which this month suspended investor withdrawals after the country's regulator opened an investigation into its trading activities. Assuming other hedge funds have also been forced to invest in illiquid high-yield assets, as seems reasonable in view of the longstanding low-rate environment, it might yet not be a one-off if redemptions suddenly accelerate elsewhere.

Indeed, the potential for liquidity mismatches has generally prompted asset owners to increase their scrutiny of managers, more generally.  

So as the global economy edges ever-closer to the current cycle's end, which hedge-fund strategies are institutional investors most hungry for? Which hedge fund strategies are in and which are out?

The following extracts have been edited for brevity and clarity.

Duncan Moir, senior investment manager for alternative investment strategies
Aberdeen Standard Investments

Duncan Moir

Hedge fund strategies continue to play an important role in institutional portfolios. However, given criticism around disappointing returns and high fees, they have seen some attrition in assets in favour of lower-cost, more-liquid solutions such as alternative risk premia, which seek to capture similar sources of returns delivered by hedge funds, but in a systematic approach with no goal of delivering alpha.                           

While alternative risk premia can be a good complement to a hedge fund portfolio, and can be customised to fit investor needs, it is not an exact replacement for hedge funds. Hedge fund replication products are available but are typically backward looking in their construction and deliver high tracking errors to benchmarks.

The most precise way to track a benchmark is to invest in the underlying constituents, but this option has only recently become available for hedge-fund investors. As investors become more familiar with using a passive approach for hedge fund portfolios, we expect these products to gain traction.

Event-driven, particularly credit-biased strategies, continue to see interest as investors’ hunt for yield continues. Macro funds have seen some outflows, having been popular in recent years, and on the whole have undershot expectations as the strategy is incredibly broad and has high dispersion of returns.

Equity long/short and market-neutral funds have come under increasing pressure after having lagged equity markets and failed to deliver uncorrelated returns. We hear increased dissatisfaction in the persistence of individual hedge fund returns, highlighting the inherent challenges facing fund selectors.  

Lyn Ngooi, hedge fund solutions investment specialist for Asia Pacific
JP Morgan Asset Management

The appetite for good, uncorrelated and/or hedged strategies has been very strong in 2019 and I would be surprised if this did not continue well into 2020.

Lyn Ngooi
Lyn Ngooi

We are in the late cycle of the market and the expectation is that returns from a broad market appreciation will be muted. Not only are we spending most of our time on returns that are less dependent on the broad direction of the market, we are looking for returns that are resilient in the event of crowding unwinds, technical sell-offs and broad factor rotations – all of these things have hurt investors over the last 12 months.

Institutional investors, and for that matter wealth managers, are looking to add hedge fund strategies that may benefit from increased market volatility and dispersion across and within asset classes.

Portfolio construction is particularly important as you want to build something that you can hold through the potentially tough times ahead.

For these reasons, we are seeing greater interest in relative value strategies – including more adaptive, uncorrelated quantitative hedge funds strategies – and seeing investors express caution about plain vanilla long short equity strategies operating at higher levels of risk (gross and net).

Han-Seng Low, executive director
UOB Alternative Investment Management

According to Bloomberg data, between January 2000 and September 2019, the Eurekahedge Asia Hedge Fund Index generated a total return that was almost three times that of the MSCI AC Asia Pacific Index. The outperformance of the hedge fund index illustrates a strong case for hedge fund strategies and their returns.

Han Seng Low
Han-Seng Low

However, we agree that there seems to be a wide dispersion of returns among hedge funds even though the fees are almost the same. Therefore, it is important that investors identify the right hedge fund manager and build a diversified portfolio to manage their costs of investment and to seek better returns.

In Asia, investors’ interest has been on market-neutral strategies such as equity long/short and macro. These strategies not only help to defend against market drawdowns, they enable investors to capture the strong alpha in the region arising from greater volatility, less efficient markets and less competition among hedge funds.

There is also interest in strategies with a bit of a long bias to capture the underlying growth potential in Asia.

Late-cycle does not mean the end of the cycle and investment opportunities remain. It might be the right time to start shifting from passive long-only strategies to actively-managed strategies that have the ability to benefit from market declines. Investors should adjust their portfolios to be less sensitive to market movements, to manage market volatility and to invest in strategies that are focused on identifying companies with good underlying fundamentals. This is because there will likely be a greater divergence in share price performance.

Paul Gambles, director
MBMG Investment Advisory
JP Morgan Asset Management’s very successful $1 billion Lynstone Special Situations fund raise shows that institutional and family office clients are either extremely committed to stressed, distressed and illiquid US and European strategies or susceptible to slick American marketing strategies. I can’t think of a less favourable sector right now than stressed/distressed (especially in Europe) or illiquid strategies, both of which would be included in any comprehensive list of the biggest bubbles in the planet. 
[Broadly speaking], if you have a negative or an uncertain outlook then liquidity, high quality, resilience and low risk beta should be the key criteria. In that case we would continue to favour market neutral equity, which encompasses many different styles. The key is to pick a good balance but Henderson UK Equity Absolute Return is a reasonable building block. 
In the related absolute return multi-asset space we currently favour London-based boutique Church House. Good long short or multi-strategy equity managers can also generate returns from your equity risk-budget without having to say sorry when the markets turn. Steve Cohen’s Point 72 and Izzy Englander’s Millennium remain our long-standing preferences here, but manager diversification is important. 
Finally, investors have most talked about AI managed portfolios – replacing traditional quants with machine learning. Sanlam’s range of funds in this space provide genuine diversification to alternative strategy and hedge allocations, although these are more boutique and thus more suitable to family office and smaller institutions. 
Article updated to include contribution from MGMG Investment Advisory. 
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