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Why instos are eyeing hedge fund strategies in the second half

Allocation to hedge funds is set to rise in the second half of the year, propelled by their strong performance in 2020 and the current macro environment.
Why instos are eyeing hedge fund strategies in the second half

Asset owners globally, and particularly in Asia, intend to increase their allocations to hedge fund for diversification and alpha, following hedge funds' strong performance in 2020, say managers and investment consultants.

Chilok Cheung, Mercer

“We are seeing more interest and enquiries in recent periods compared to the last few years,” Chilok Cheung, portfolio manager in delegated investment solutions at Mercer told AsianInvestor.

Besides enhancing returns, hedge funds can be a powerful risk diversification tool, Cheung explained. “Hedge fund allocations can lower your overall risk profile because they are typically uncorrelated with the traditional asset classes,” he said.

A survey conducted by UK intelligence firm HFM and the Alternative Investment Managers Association (AIMA) published in July showed 34% of investors plan to increase their allocation to hedge funds in the second half of 2021.

Isolating Asia Pacific investors, the intention is stronger still: 46% planned to increase their allocation to hedge funds and only 8% planned to decrease it.

According to HFM data, hedge funds achieved returns of 8.9% in the first half of 2021 -- the strongest first-half performance since 2009 (9.4%). In 2020, hedge funds achieved returns of 12%.

Cambridge Associates' managing director of hedge funds Damien Tan concurred: “We are indeed seeing an increased interest in hedge funds amongst institutional investors over the past couple of years.”

Damien Tan, CA

He explained the low interest rate environment (which limits the ability of high quality government bonds and investment grade credit to act as diversifiers) and high equity valuations are prompting their clients to increase allocations to hedge funds to provide downside protection.

“Institutional investors from our experience have typically invested around 15% to 20%+ in hedge funds, depending on their risk profile and liquidity needs.

"But more recently, even some of our clients with relatively low risk tolerance are putting up to 40% or more in hedge funds because of that volatility dampening role, to provide diversification, generate alpha and enhance risk adjusted returns,” he told AsianInvestor.

Alternatives – which also include private debt and private equity – are as a whole growing in institutional investors’ portfolios. The increase in allocation to hedge funds is not simply the result of the alts pie growing," Tan said.

“Hedge funds are also growing within alternatives.”

Hedge funds are becoming more appealing relative to private equity due to their higher liquidity, explained Wout Kalis, head of Asia Pacific sales for alternatives at BNY Mellon. While lock-up periods for private equity are usually at least five years, for hedge funds they can be as low as one year.

A June survey by BNY Mellon and Mergermarket confirms the HFM-AIMA report findings and consultants’ observations: 81% of 100 global asset owners and 100 asset managers said they saw hedge fund investments as attractive, up from 59% in 2017.

On average, investors surveyed planned to increase their allocation to hedge funds from 7% in 2019 to 8% in the coming year. Only private equity will see a bigger surge in portfolios, with institutional investors planning to increase allocations from 24% in 2019 to 27%. Over half of investors said hedge funds performed better than they had expected over the past 12 months, compared to under a third for private equity.

TOP STRATEGIES

Within hedge funds, the top strategy according to the BNY Mellon report is special situations. These involve investing in stocks whose price has been temporarily weakened due to current circumstance (for example Covid-19) but which don’t reflect underlying fundamentals.

The HFM-AIMA report in turn finds global macro, long-short equity and multi-strategy as the most appealing. Global macro aims to capitalise on economic trends, while long-short bets on the relative performances of various baskets of equities.

Kevin Jeffrey, WTW

More generally, dispersion of returns and market volatility are two factors under which hedge fund strategies perform well, said Kevin Jeffrey, director of investments for Asia at Willis Towers Watson (WTW).

“The past 18 months have provided both volatility and dispersion, and many hedge funds and even active long-only managers, have capitalised on this,” he added.

The current uncertainty around inflation and interest rates continues to provide a favourable environment for hedge funds, Mercer’s Cheung said, adding investors should decide on their motivation for allocating to hedge funds – diversification, alpha, or both – to determine the best strategy for them.

FEES, COMPLEXITY

Hedge fund fees have come also come under pressure in recent years.

“The days of 2% base and 20% performance fees as the market standard are well behind us,” said Jeffrey.

More actively managed strategies generally carry higher fees, as do separately managed accounts, which give investors more transparency and customisation. Nevertheless, institutional investors are favouring managed accounts over fund of hedge funds and standard funds, BNY Mellon’s report shows.

Besides fees, the perceived complexity of hedge funds relative to other alternatives can act as a disincentive for institutional investors. In 2014, California Public Employees' Retirement System announced it was divesting its $4 billion stake in hedge funds, citing fees and complexity.

Some institutional investors may be constrained by strict investment policies that limit the amount they can allocate to complex or illiquid strategies, said Cheung. They may be also concerned about the high leverage and use of derivatives that are common among hedge funds.

“There is a temptation of hedge fund managers to go outside the liquidity spectrum and beyond the normal risk level because they see attractive opportunities and want to continue to generate attractive returns,” said Cheung.

This story has been updated to clarify the job title of Wout Kalis, and specify the identity of Chilok Cheung as the provider of the last quote.  

¬ Haymarket Media Limited. All rights reserved.
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