Asset owners look likely to start investing in a selection of hedge fund strategies as they seek to better navigate jittery markets this year, despite the ongoing poor returns of the asset class, industry practitioners told AsianInvestor.

The potential rise in engagement comes at a time the asset class as a whole continues to struggle. A dataset produced by alternatives data provider Preqin on January 22 revealed that 59% of active hedge funds had negative annual net returns in 2018.

Preqin 2018 hedge fund return
Source: Preqin

“Hedge funds finished the year with losses of 3.42%, the lowest return the industry has seen since 2008,” noted the report.

But several consultants and fund managers said this could offer an impetus for asset owners to invest, particularly given that many view hedge funds as a form of risk mitigation and diversification.

“We’re glad to see that Preqin wrote that hedge funds had a terrible year [in 2018]; that makes now a potentially good time to place more assets into that space,” said Paul Colwell, head of advisory portfolio group for Asia at Willis Towers Watson. “We believe asset owners could put more assets into liquid and alternative beta [strategies] and hedge funds, as they are typically less sensitive to market volatility,” he noted.

Part of the potential appeal of hedge funds is that their returns were not as bad as some other asset classes, such as equities and high yield bonds. FTSE 100 saw its biggest annual decline in 10 years in 2018, losing 12.5%, while Preqin All-Strategies Hedge Fund benchmark and Eurekahedge Hedge Fund Index dipped 3.42% and 4.08% respectively. The purpose of a classical hedge fund is to outperform a falling market, and many achieved this in 2018. 

Added to this, some observers believe hedge funds have more opportunity to do well this year.

 “I think in 2019 hedge fund performance will improve. I would say that the performance challenges in the past came from the lack of dispersion in the market the fact that it was really a beta-driven market - and not necessarily the right conditions for hedge funds to perform,” said Shawn Khazzam, Asia Pacific head of alternatives solutions group, JP Morgan Asset Management.

He noted there were some mitigating factors for hedge funds' relatively poor performance over the past decade.

“Volatility has been at a hundred-year low prior to the events of 2018, and that’s not necessarily the best environment for hedge funds to perform either.”

HEDGE FUND STRATEGIES

However, not all hedge fund strategies are created equal. Industry professionals singled out a few strategies as being the most likely to interest investors, depending on whether they were seeking to maximise yield or minimise the impact of volatility on their portfolios.

“Long-short will be a strategy that tends to benefit from the dispersion that tends to come with volatility as well as rising rates,” Khazzam told AsianInvestor.

“The second strategy that I think [is appealing] is relative value, and that would really come down to statistical arbitrage short and medium term, it would also benefit from some of the dispersion that we are seeing in markets. And then also I’d say that the environment for macro strategies we think would be better going into 2019 compared to 2018,” he noted.

Long-short strategies involve taking long positions in stocks expected to rise and short positions in those expected to fall, while macro strategies wager on the macroeconomic conditions of various countries using instruments including equity and fixed income. Relative value strategies aim to capture the difference in prices of related instruments by selling and buying those stocks or bonds simultaneously. 

Ryan Korinke, head of hedge fund and quantitative strategies at Pimco in Hong Kong, agreed that discretionary macro strategy funds and also managed futures funds could benefit from uncertain investors looking to limit their market risk, as they performed particularly well in the fourth quarter of 2018.

“Many investors have begun showing an interest in macro hedge funds or tail risk hedging strategies over the past six months or so, and that could well continue,” he told AsianInvestor.

CHALLENGES AHEAD

The hedge fund asset class as a whole enjoyed a gradual increase in AUM in 2018, rising from $3.01 trillion in the second quarter last year to $3.06 trillion in the third quarter, noted a Barclays Hedge factsheet

But the asset class still faces some big issues, primarily its cost. The 2 and 20 model, in which funds charge a flat 2% rate on assets under management and 20% of profits earned, has largely subsided, but funds often charge respective amounts of 1% and 10% or more. 

Challenges in allocating to the asset class such as “high and poorly structured fee schedules” remain an area of concern, according to a hedge fund report by Willis Towers Watson, released on February 1.

“Additionally, headline fees don’t always capture additional expenses which are regularly, to the detriment of asset owners, disregarded by hedge fund investors,” added the report, which also calls for greater transparency across the asset class.

The report also noted that would-be investors into hedge funds should be aware of headwinds that could suppress returns from new-found opportunities, including a manager’s skills in managing enterprise risks.

Enterprise risks incur when hedge fund managers spend too much time protecting base management fee revenues rather than delivering the performance objectives for clients, the report noted.

Korinke predicted that a combination of the poor absolute performance of hedge funds in 2018 and relatively high fees will mean the industry as a whole sees AUM outflows this year.

“It’s one thing to outperform but if you’re losing money and other assets are also down, it’s challenging from an investor standpoint on where to put your money.”

Richard Morrow contributed to this story.