Amid widespread wariness over hedge funds after years of underperformance, some asset owners are daring to be contrarians.

Korea’s $442 billion National Pension Service, for instance, made its first foray via a fund-of-hedge-funds structure this year. It announced in July an allocation of up to $500 million, or 0.2% of its assets, to two managers, with investments slated to be made next year.

Australia’s $106 billion Future Fund has also remained bullish towards hedge funds and could yet increase its 12% asset allocation.

What pushes these institutions to have faith where others are losing theirs?

In part, it’s down to diversification and education. Asset owners need to look beyond short-term return figures and should be clear on what role hedge funds play within their portfolio, suggest consultants.

That’s easier said than done. It certainly helps to be a big, well-resourced institution when it comes to evaluating investment strategies. But hedge funds could do more to help themselves and become better communicators too.

The importance of selection

Asset owners that continue to invest in hedge funds tend to be those that can analyse and monitor specific strategies and managers.

Take Australia's Future Fund. It has A$15 billion allocated to hedge funds, and nine of its investment team members work closely with the managers it chooses. The institution's chief investment officer, Raphael Arndt, told AsianInvestor: “We worked very hard to understand, to analyse how managers make money.

"It’s not enough to just do well – we have to know they are doing well because of their skill, not simply through exposure to equity beta or other market factors," he added. "We look carefully at the fee structure – what proportion of that skill-based return is kept by the manager and what proportion is allowed to passed through to investors.” 

Future Fund has focused its exposure on diversifying portfolio risk away from listed equity, credit and interest rate exposure. It has had to be hands-on doing so. The fund teams up with managers opportunistically and has turned over several managers in the past two years as it moved out of strategies that no longer provided value.  

Arndt confessed that it was hard to find managers who can continue to deliver.

“Too many hedge funds don’t provide true diversification, and are simply expensive vehicles to access bulk betas,” he said. "Any approach that allows the payment of high fees and agreeing to illiquid structures just to get what we could buy cheaply and in liquid form in public markets is bound to disappoint."

 Raphael Arndt, Future Fund

To improve its chances of success, Future Fund has started seeding hedge fund managers.

“By supporting newer and emerging new managers and negotiating future capacity rights, and terms and liquidity up front, we are better able to help establish the fund and get something for us in return,” Arndt said.

Long-term perspective

Simon Potter, Hong Kong-based director at UK fund-of-funds firm Nanjia Capital, said asset owners have pulled money out of hedge funds largely because they view the vehicles from a short-term perspective, without considering their longer-term hedging value.

“They think hedge funds have not performed as well as ETFs or the market recently and therefore are looking to sell back,” noted Potter. "That is a very basic way of looking at asset allocation."

The key is to understand when the various hedge fund strategies perform well and to match these with their risk/return requirements and liquidity needs, he added.

“If you compare average US hedge fund performance versus the S&P 500 Index since 2000 then hedge funds have outperformed significantly,” noted Potter. An investment of $100,000 would have generated a compound return of $459,000 from US hedge funds versus $313,000 from the index, he said.

“Hedge funds outperformed significantly mainly due to outperformance in bear markets in 2000, 2001 and 2008, despite underperforming in a number of the other years,” he argued. In other words, hedge funds did the job they are supposed to do.

Communication constraints

Hedge funds must play a role too, by better explaining what value they offer to build trust among asset owners.

“Hedge fund managers that run very large amounts of institutional capital need to work with their investors to explain what they are doing,” said Potter. "They can afford competent investor relations teams."

William Ma, CIO at Chinese wealth manager Noah Holdings, is less forgiving. He believes that in addition to improving communication with investors, hedge funds should charge lower fees, and more consistently beat competitors like exchange-traded funds and risk premia strategies.

However, the funds may have an opportunity here, as they can do things that other funds can’t. For example, smart beta can’t replicate arbitrage strategy.

“I can see the argument that [hedge funds are] expensive, but this is not a new argument,” said Ma. "And the negative alpha: it’s like 2008, hence we see asset owners questioning hedge funds [again]."

In truth, asset owners like Future Fund are the exception. Most institutional investors don’t have a great deal of experience understanding the real value offered by hedge funds.

And while hedge funds are typically based on personal relationships and trust, years of underperformance and today’s abnormal market environment have left struggling funds bereft of both. Add to this the funds’ failure to explain well what they do and why, and they have seemed to lack conviction.

Yet many investors are so mistrustful of hedge funds that they often fail to appreciate that some can offer extra value, in the right market circumstances. This may be a mistake.

Future Fund’s Arndt believes asset owners need to understand how a hedge fund manager is investing and that governance in the industry can be improved. But he argued that jettisoning the asset class entirely wasn't the answer.

“Larger [institutions] that do not use hedge funds are cutting out one option from the universe of opportunities that is potentially going to deliver returns when you need them most,” he added.