Hedge Funds Are Far From Dead; Understanding Liquid AltsVW Staff
Hedge Funds Put Into Perspective by Skenderbeg Asset Management
Why The Hedge Fund Industry Should Welcome The Pain It’s Experiencing
Don Steinbrugge, a managing partner of the Richmond, Virginia-based Agecroft Partners, a marketing and consulting firm for the hedge fund industry, predicted in January there would be an “all-time high” in hedge fund closures in 2016. “I think there will be,” he tells Yahoo Finance, “The first quarter was not good for the hedge fund industry. You saw significant dispersion of returns between managers in simi-lar strategies and whenever you have this huge dispersion of return—and in some cases it was over 20% difference in performance of hedge funds within a certain strategy—underperformers are going to get redeemed and go out of business.” This, however, creates op-portunities for the funds that are doing well.
It’s a “very small percentage” that left the industry, Steinbrugge notes. He also doesn’t think it’s going to leave the industry entirely. “Most of it’s going to either recirculate to those managers who did well or it’s going to shift between strategies,” he says. “I think what you’re going to see is money move from beta-oriented strategies to strategies that are not correlated with the capital markets.”
Another issues that’s been brought up lately is the incredible number of hedge funds in the space. Steve Cohen, who runs $11 billion family office Point72 Asset Management (formerly SAC Capital), recently said there are “too many players.”
“I think there are [too many],” Steinbrugge says, “I think 85 to 90% of fund managers are not worth the fees they’re paid,” he says, adding “I think there are 10 to 15% out there that are really talented.” Steinbrugge thinks there are a number of strategies you can’t replicate with indices or ETFs and that it’s the job of sophisticated investors to identify those managers who have the ability to generate superior alpha.
Even though there’s been a great deal of criticism directed toward hedge funds by both investors and managers, Steinbrugge says the industry isn’t going anywhere. It may contract a bit, but the overall amount of money leaving will be relatively small. “I just don’t see a lot of pension funds pulling out because there aren’t great alternatives for them to allocate their capital.”
Hedge Funds Are Far From Dead
Hedge funds are down, but far from out.
The New York state pension is among the big-money investors pumping more money into hedge funds and other “alternative investments” despite bad publicity and public pressure. The $178 billion New York State Common Retirement Fund has added $550 million in alternative investments, a category that also includes private equity, according to Preqin, a data provider for asset managers. A spokeswoman said the pension’s managers are “continually reexamining our allocations to various alternatives” and alternative investments continue to be part of its investment strategy.
Hedge funds saw their assets swell to more than $3 trillion over the past decade as pensions, endowments and insurers desperately chased returns. But with hedge fund returns lagging the broader stock market and the high-fee structure making them less attractive, some pensions are pulling back. Earlier this year, the California Public Employees’ Retirement System and New York City Employees Retirement System an-nounced plans to exit their hedge fund positions, citing high fees and disappointing returns.
Those moves, along with several high-profile hedge fund closures, had some industry observers predicting that hedge funds had peaked and were on the way out as a preferred investment class. In May, sentiment was so sour that private-equity titan David Rubenstein played the part of a cheerleader and urged his fellow alternative money managers not to be embarrassed to work in the industry at the annual SALT conference in Las Vegas. “There has been so much negative press against hedge funds this year and for the right reasons,” said Alper Ince, a managing director at Paamco. “However, for some of the headlines about pension funds leaving, many are adding hedge funds to their allocation.”
Compared to other big investors like endowments and family offices, pension funds had lower rates of hedge fund redemptions in the first half of the year, according to a Credit Suisse report. The report also found that more than 60 percent of redemptions were driven by specific manager performance instead of displeasure with the asset class as a whole.
A report by global advisory firm Willis Towers Watson also bolstered the case for hedge funds investments. “The need for diversity away from traditional equities is the strongest it has been in several years in our opinion,” read the report. Of the hundred alternative asset man-agers surveyed, the report found that total assets managed grew to $3.6 trillion in 2015, representing a 3 percent increase from the previous year. Of that total, pension funds represented the largest investors in the alternative space, accounting for 34 percent of the total assets managed by the top 100 asset managers.
Even so, pension funds have become increasingly discerning about the fee structure of alternative investments. “The alternative asset man-agement industry continues to be remarkably reliant on pension fund money and has earned a position of trust by delivering diversified re-turns via some of the most highly skilled investment teams around,” Brad Morrow of Willis Towers Watson said in a statement. “However, there’s an ever-increasing demand for more alignment and lower cost.”
Hedge Fund Managers See No Long-Term Brexit Damage In Survey
Global market turmoil triggered by Britain’s vote to exit the European Union will have no long-term effect on investments in the UK, accord-ing to hedge fund managers surveyed by Preqin.
Almost a quarter of the 67 money managers questioned by the research firm from June 30 to July 4 expect a positive effect, while none said Brexit will be negative. Over the short-term, 31 percent of respondents said the decision will have a positive influence on their funds’ perfor-mance and 13 percent considered it a reason for concern.
About 20 percent of the hedge-fund managers surveyed said they will raise investments in the UK over the next 12 months, while 11 percent said they will reduce investments in the short term, the survey showed.
It Is About Performance, Not Fees
The chorus of investors complaining about hedge fund fees is getting louder as performance continues to get softer. This past weekend, the Old Gray Lady once again featured a piece on why managers are doing all they can to quiet the sound coming from investors by offering new fee structures — a new take on the two and twenty that has been the standard hedge fund fee of late, but still higher than fees charge by traditional managers.
And while I very rarely agree with the liberal-leaning New York Times, this week they may have got it right, sort of. Investors should be screaming about paying too much: Performance is bad and managers aren’t delivering, but a discount isn’t the answer. What investors should do is to take a page from the presumptive Republican nominee and tell managers that they’re fired.
Forget the discount. When a manager doesn’t deliver, the investor should redeem. The manager’s job is simple: Deliver alpha. That means doing well when markets are rising and protecting assets when markets are falling. If they can’t do that, well, guess what, they don’t deserve to be managing money. It’s really pretty simple: It’s not about fees, it’s about performance. I have said many times that those who complain about fees are those who cannot charge them. Now it seems that investors are complaining about fees because the managers aren’t per-forming. Well, guess what, they’re right. Investors, beware. Just because something is on sale doesn’t mean it’s good, it just means it’s cheaper.
Understanding Liquid Alternatives: Ask The Right Questions
Financial advisors and other professional investors often have a lot of questions about liquid alternatives, and for good reason. The invest-ment strategies used in alternative mutual funds and ETFs are not straight forward by any means. Many use some form of leverage. Most utilize the ability to short securities, while others use a variety of derivative instruments to efficiently gain exposure to certain assets classes or securities.
But when used properly, liquid alternatives can be an effective tool to mitigate risk, increase diversification and/or enhance returns. So what questions should advisors be asking? To answer that question, Cognios Capital, has produced a handy guide, “FAQ: Liquid Alternatives.” The eight-page white paper answers the following frequently asked questions:
- What is the difference between traditional alternative investments and liquid alternatives?
- What is the benefit of adding alternatives to my portfolio?
- How many different alternative strategies do I need?
- From where should I fund my alternative allocation?
- Are there risks that are unique to alternatives?
- Why not just invest in a multi-strategy fund?
- Why is there such a large difference in returns among the different types of alternative strategies?
- What does it mean to be Beta Neutral?
- How are fees and expenses reported for alternative mutual funds?
Cognios’s white paper answers each of the above queries in great detail, devoting nearly a page to each answer. What follows is an abbrevi-ated summary of the report.
Traditional vs. liquid alts
Alternative investments include assets such as commodities, currencies, and private equity; as well as public-equity strategies such as long/short equity, market neutral, and equity arbitrage. Traditional alternatives are subject to less stringent regulation by the SEC, have less liquidity and transparency than liquid alts, and are open to wealthy individuals and institutions only. Liquid alts offer similar exposures but through SEC-regulated mutual funds and ETFs, with daily liquidity and greater transparency.
Benefits of allocating to alts
Alternatives present many potential benefits, but perhaps the most obvious is their potential to improve the risk-adjusted return of portfo-lios through exposure to assets and strategies with low correlation to traditional stocks and bonds.
How many alts are needed?
According to Cognios, a 10% to 25% allocation “may be an optimal range” for individual investors. As for the optimal number of different alternative strategies, this depends on investors’ desired outcomes. Alternatives aren’t a single “asset class” – a variety of strategies pursue a variety of different outcomes.
Funding an alts allocation
Should alternatives be funded from the equity portion of a portfolio, the fixed-income sleeve, or a separate “alts” sleeve? According to Cognios, there is no one right time to add alts to a portfolio – and similarly, there is no one right way to fund them.
Cognios cites the following as unique risks to investing in alts:
- Insufficient manager experience
- Limited track records
- Difficult-to-understand strategies
Investing in a multi-strategy fund leaves the decision of which strategies to invest in and how much to allocate to each strategy up to an out-side manager. While this can be beneficial, multi-strategy funds sacrifice customization for ease. Furthermore, multi-strategy funds aren’t always fully diversified within the alts space, so certain single strategy funds may be needed to complement multi-strategy holdings.
Dispersion of returns
Since alts aren’t a single “asset class,” it makes sense that there would be a wide dispersion of returns across the different alternative assets and strategies. But even within a given strategy, wide dispersion between the best and worst performers is common, since many funds oper-ate different sub-strategies and most are unconstrained by benchmarks.
A “beta” of 1.0 indicates 100% correlation with a given benchmark. Equity market neutral funds pursue “beta neutrality,” meaning a beta of as close to 0.0 as possible. This way, their returns are isolated from the fluctuations of the broad market.
Liquid alts fees
While alternative mutual funds certainly have lower fees than their hedge-fund counterparts (in most cases, at least), their fees aren’t neces-sarily as straightforward as those of traditional mutual funds. This is because strategies that engage in short-selling incur related costs, whereas traditional mutual funds don’t sell short, and thus don’t incur these added charges.
Download the full guide for complete answers to the nine questions: FAQ: Liquid Alternatives
The Case For Absolute Return
Talk about diversification comes cheap. Actually diversifying one’s portfolio is far more difficult.
We have been preaching for some time that in an era where both stocks and bonds may be expensive, investors may want to embrace alter-native investments. I have been quoted saying that unless investors have at least 20% in alternative investments, they may not be truly diver-sified. While that quote made some headlines at the time, many college endowments have a far greater allocation to alternatives, at times more than half of their portfolio. There may be a good reason for that; let me elaborate and make a case why, in this context, investors may want to consider absolute return investing.
Goal of diversification
Diversification is at times described as the one free lunch Wall Street has to offer: by adding a return stream with low correlation to other investments, risk-adjusted returns might be enhanced. While it’s theoretically possible to enhance risk-adjusted return with an asset that has negative returns, I have yet to meet investors embracing an investment with expected negative returns merely for its correlation attributes.
Absolute return: Alternative investments for today’s markets?
Tying this all together, we believe investors may want to have a closer look at absolute return strategies. As a class of alternatives they have had a patchy track record, but we believe they deserve a second look.
See the full PDF below.