The decision made last September by CalPERS to divest its USD4bn hedge fund investment plan came as quite a shock to the industry. Then, in early January this year, PFZW, the EUR156 billion Dutch healthcare scheme, announced that it had ended its exposure to hedge funds in December 2014.
The question that arises from these decisions is: will more pension plans turn their backs on hedge funds in 2015?
For Jean-Marc Stenger, CIO, Lyxor Alternative Investments, the above events are outliers rather than representing a symptom of a wider trend.
“When speaking to our investors and market prospects we don’t get a sense that this is the start of a new trend; quite the opposite. These were very specific cases. Overall, institutional investors continue to allocate strongly to hedge funds. I saw a figure from Preqin the other day that more than USD450 billion had been added to global hedge funds in 2014,” says Stenger.
There don’t appear to be any early warning signs that institutional is suddenly about to exit hedge funds. In its 13th annual Alternative Investment Survey, Deutsche Bank forecasts that global hedge fund assets are set to surpass USD3tn by year-end and grow a further seven per cent. The report writes: “Institutional investment in hedge funds is set to increase, with 39 per cent of these investors planning to increase their allocation to hedge funds in 2015.”
Naturally, when a large pension plan exits the hedge fund space, it makes headlines. But if the above figures prove prescient, there is no reason to suspect that managers need to fear a backlash from institutions, despite mediocre performance last year.
One of the reasons that CalPERS divested was the amount it was paying in fees; an estimated USD135 million in its last fiscal year and USD115 million the year previously. Ted Eliopoulos, interim CIO at CalPERS was quoted by Forbes at the time as saying: “One of our fundamental investment principles is that cost matters.”
The question institutions face, according to Stenger, is what size of allocation represents the most meaningful level to optimise their hedge fund exposure? In his view, it’s not a question of whether they should or should not be investing in hedge funds; given today’s market conditions, where equity markets are becoming “toppish” and rates are at all-time lows, they have precious little choice. They need to add further resilience to their portfolios by allocating to hedge funds.
“The hedge fund industry is maturing today. Strategies we find in the space today are more diversified but also more specific compared to a few years ago. Ten years ago, when institutional investors were allocating to hedge funds they discussed with consultants, did their research and would ultimately end up allocating five or six per cent as a total weight of their portfolio to a handful of specific hedge fund strategies,” says Stenger.
The point here is, they were allocating to hedge funds separately to their broader equity and fixed income holdings.
Strategies were chosen that fitted well within their traditional portfolios; liquid long/short equities to diversify their equity risk, fixed income arbitrage or specific global macro strategies that complemented their long-only fixed income allocations. These strategies brought something different to the portfolio.
“Now, institutions are migrating away from this limited use of hedge fund strategies and trying to integrate them into their wider portfolios. This can achieve two things:
“First, you bring something meaningful to the portfolio i.e. a clearer understanding of how hedge funds bring value to the overall portfolio, rather them viewing them as a separate part of the portfolio. I think that’s partly why CalPERS divested their allocations, they probably weren’t ready to make that move.
“Second, when more straightforward strategies are used it should allow investors to avoid paying the usual 2/20 fees. If it’s a long/short equity fund sitting within the overall equities allocation, there is going to be a certain amount of market beta and as such, the fees should come down. For these types of strategies, investors should be paying 1.5 per cent and anywhere between 0 per cent and 15 per cent in performance fees because there is a clear rationale for doing so.
“Both investors and, importantly, managers are becoming more understanding of this,” states Stenger.
Global markets are growing at different speeds
Market conditions are becoming more favourable for hedge fund managers. The oil crisis has led to opportunities to exploit trends in commodities, which has favoured CTAs and global macro managers, volatility has picked up and the degree of correlation across asset classes is falling. Moreover, the economies of the US and the UK are growing at a much stronger rate than Europe, and parts of Asia, creating good opportunities for fixed income arbitrage strategies.
At the same time, pension funds are realising that the performance they’ve enjoyed from equities and bonds in their traditional portfolios over the last five years cannot hope to be replicated over the next five years. That paradigm of central bank intervention artificially inflating the markets is over.
“Without wanting to sound too dramatic, over a longer horizon the performance of a balanced portfolio, not only in nominal terms but also in real terms, is likely to be lower than what we have gotten used to.
“We are not saying that rates will necessarily be higher at the end of 2015. They could still fall. But over a 5-year time horizon, that trend is over unless you believe that US 10-year Treasuries can fall to -2 per cent,” Michaël Malquarti, co-head of alternative investments at Syz Asset Management SA told Hedgeweek recently.
In Stenger’s view, this is a good reason for institutions to continue their faith in allocating to hedge funds.
“There are two points to make here:
“The first is that when you are an institutional investor, you do not face many options. There aren’t many alternatives within the alternatives space. You cannot allocate massively to areas such as infrastructure projects or illiquid fixed income simply because these markets aren’t deep enough or liquid enough to offer a true, legitimate alternative.
“Apart from allocating to financial markets through hedge funds, investors have precious few alternatives.
“The second point is that hedge fund managers are more cognizant of this issue. Probably a few years ago it was not that obvious. Now, managers better understand the regulatory environment with respect to AIFMD, UCITS and ’40 Act funds. It’s been a massive hurdle for them to overcome but I think this will become a massive opportunity over the next couple of years.
“These regulations are there to bring comfort to investors such as trustees of smaller pension plans who might have previously been reluctant to invest in offshore funds. This creates a suitable framework for investors in Europe to feel more comfortable investing in hedge fund strategies,” explains Stenger.
If managers are able to repackage their strategies into AIFMD-compliant funds, for example, without changing their investment style, at a time when markets are strongly pushing institutions to allocate into hedge fund strategies, it could create a “perfect marriage”, according to Stenger.
AIFMD – a comfort blanket
Anecdotally, Hedgeweek has heard that European institutions are approaching US managers to write sizeable tickets on the condition that they establish an AIF, preferring not to invest into offshore commingled funds. AIFMD is providing the catalyst for this interest. This is good news for managers, both European and non-European.
Indeed, Lyxor itself is evolving its business model in line with these developments under AIFMD. Whereas Lyxor’s managed account platform was previously domiciled in Jersey, over the past six months or more the firm has been busy transferring the MAP onshore to Luxembourg. This is to ensure that managers can continue to freely raise assets across Europe for their strategies, and keeps the supply side open to institutional investors.
“We are offering the managed account as an AIFMD-compliant vehicle to allow managers to offer their strategies to the European market and to the Asia market, which also has strong interest in AIFMD and UCITS-compliant funds. We have around 85 funds on the platform. We will be transferring them in batches to Luxembourg over the course of 2015,” says Stenger.
It is developments such as these that should give institutions further reassurances about investing into hedge funds. As long as they have transparency, control of the assets, good liquidity terms and the ability to better negotiate fees, pension plans and insurance companies, broadly speaking, will in all probability continue to integrate hedge funds into their wider portfolios.
Transparency is a particular metric that insurance companies must now factor in to their alternative investments. They have the option of choosing alternative UCITS funds, but managed accounts are better suited in many ways as they allow investors to customize their mandates and, at the same time, receive substantial granularity at the position level in those mandates.
This too should help investors keep the faith.
“Insurance companies here in Europe find themselves having to comply with Solvency II regulations. If they don’t have look-through capabilities and full transparency on their hedge fund strategies they will end up paying higher capital requirements than necessary. They can’t allocate to a black box. They need the ability to integrate hedge funds into their broader portfolio to determine what their different exposures are. This allows them to do stress testing across the portfolio, but it requires transparency. Managed accounts are designed specifically to provide that.
“We have developed a website specifically for investors to view and aggregate their hedge fund exposure with their mutual fund exposure in a single portal – www.MyLyxorMap.com. It gives them a sense of how, and to what extent, different managers might be affected by moves in the market. It allows investors to estimate what the overall impact such moves might be on their portfolios. It provides them with a lot more comfort compared to what was the case 10 years ago,” says Stenger.
Challenges of manager selection
Some industry commentators think that the hedge fund market is overcapitalized. Certainly, at the upper echelons of the industry, where the USD5 billion-plus managers reside, institutions continue to play safe and park their money with these established blue-chip names. For them it reduces career risk and also helps get any new hedge fund allocation approved by the trustees.
The point about overcapitalization is that some funds have become so large that one could best describe them as asset gatherers. They can’t take prominent positions in markets for fear of moving them, risk is reduced, the management fees are substantial and the overall desire to aggressively capture alpha is less pronounced than smaller managers.
Obviously, different institutions will approach their hedge fund investments in different ways. If they want steady, lower volatile returns larger managers are more likely to fit this profile than a hungry start-up or emerging manager. Equally, if an institution is happy to take on more risk they might well favour small- to mid-sized managers where returns might be higher, but drawdowns might be more pronounced.
There’s no right or wrong answer to this. But if institutions are to keep allocating to hedge funds moving forward, understanding precisely what they are trying to achieve from the outset will be crucial.
In Stenger’s view, it’s not merely a case of manager size that dictates potential performance but the specific investment framework they have in place.
“There are plenty of excellent multi-billion dollar managers performing extremely well, generating market outperformance and running highly scalable strategies. Equally, there are managers who are perhaps running too much capital (which is impacting on performance), in which case one should focus more on smaller managers. It really depends. The same issues exist in the traditional long-only space.
“You need to be selective, to understand what is at stake, but size in and of itself is not a function of performance. We take into account the quality of managers on two levels. First, their ability to generate returns, obviously. Second, their operational risk. When someone is managing a lot of assets, they need to have excellent operations staff to manage the day-to-day functionality of the fund.
“My view is you need to allocate to all types of managers – small, large, established, emerging. We are agnostic. In our experience, mixing the entrepreneurial spirit of emerging managers with the institutional managed account structure that we provide at Lyxor works very well. We conduct independent risk oversight on the manager. We put good fund governance controls in place, and this gives institutions access to the best emerging managers,” explains Stenger.
Lyxor now has a special partnership in place called Lyxor Active Partners to help smaller managers grow within the industry by allocating capital and exposing them to larger institutions.
Looking ahead, Stenger thinks hedge funds will become more mainstream. "If the hedge fund industry evolves its fee structure, and offers new ways to access strategies as a result of regulation, then there’s every reason to be optimistic on the future growth of the asset class", he says
