Hedge funds losing lustre after years of underperformance

Many asset owners are pulling out of hedge funds, dismayed by their relatively high fees and low returns. Others, including some Asian institutions, are reviewing their allocations.
Hedge funds losing lustre after years of underperformance

Hedge funds were once investment darlings. In the years before the global financial crisis of 2008 they flourished, supported by investors eager to benefit from their investing smarts.

Times have changed.

Today, an asset exodus is taking place from the hedge fund industry. An investment director at a sovereign wealth fund in North Asia succinctly summed up the situation: “It is rare now to hear asset owners adding hedge fund allocation. What we hear is a lot of asset owners evaluating their existing allocation and, if anything, there will be a reduction.”

There are good reasons for this: most hedge funds are failing to do what they promise, yet they continue to charge a fortune.

As of the end of November, the industry offered an average return of 3.69% for 2016, according to the Eurekahedge Hedge Fund Index. That was less than half the gains offered by the S&P 500.  For such pathetic performance, hedge funds traditionally charge 2% of assets they manage as an annual fee, plus 20% of profits.

“Charging a fine-dining fee for McDonald’s fare quickly becomes unpalatable,” one asset owner executive told AsianInvestor.

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Scepticism about hedge funds has been on the rise for some time, on the back of woeful performance. As an industry, hedge funds have performed below the S&P 500 index every year since 2009, apart from 2015.

Investors have reached unprecedented level of scepticism about these strategies. In a June survey by alternative asset data provider Preqin, four out of every five investors expressed disappointment with hedge funds’ failure to meet their return expectations over the previous 12 months.

The lacklustre performance is the result of several factors.

One is trade overcrowding. As individual hedge funds gain assets, they tend to end up chasing similar strategies and themes. When a market correction happens, these managers find it challenging to liquidate their investments, explained William Ma, chief investment officer at Chinese wealth management firm Noah Holdings.

Market liquidity has also shrunk as investment banks cut back on proprietary trading, which has created swings in volatility, he added.

In 2014, the $295 billion California Public Employees’ Retirement System (Calpers) announced that it would divest its entire $4 billion in hedge fund allocations. Many other international asset owners followed.While the investing environment has been tougher, hedge funds are meant to show their mettle in difficult markets. The failure of the industry to do so has led several major investors to lose faith.

Most recently, in October, the $7.6 billion Employees Retirement System of Rhode Island (ERSRI), said it would halve its $1.1 billion allocation over the next two years. The reason? They were expensive and failing to do their job.

“At the end of the day, absolute return strategies need to generate positive returns and provide legitimate protection from market risk in order to justify their fee structure,” general treasurer Seth Magaziner was quoted as saying to the press.

Just a few weeks into the year, and asset owners have already pulled some $50 billion in AUM from hedge funds in 2017 — much of that from the industry’s biggest and best-known funds, according to Hedge Fund Research.

This is despite the fact that many market participants argue that hedge funds are well suited to profit from the volatile environment likely to be brought about by new US president Donald Trump.

On the fence

Asian asset owners have become similarly sceptical about hedge funds, including South Korea’s Military Mutual Aid Association (MMAA) and Police Mutual Aid Association.

“Whenever an event happens, hedge funds which claim to pursue absolute returns end up with valuation losses of 10% to 20%, so it is difficult to continue to invest there,” Lee Sang-ho, chief investment officer of MMAA, was quoted as saying by local publication Korean Investors in July. The $8 billion fund has a $60 million allocation to hedge funds and will not be adding to it for the time being.

The investment director of at the North Asian SWF said his fund had a sizeable allocation to hedge funds, but was on the fence over what to do with this investment.

He said his fund could start selling down if managers continued to underperform or remained inflexible over fees. Perhaps the biggest motivator would be if other big international asset owners were to divest. In this industry, peer pressure counts for a lot.

But while returns have been poor, particularly versus other investment classes, losses to date haven’t been that big. This is keeping the funds in the game — just. 

“Hedge fund performance has been lacklustre, but asset owners have not lost a lot of money,” said the SWF investment director. "It doesn’t hurt investors that much yet."

The longer they fail to perform, the more this could change. Already some frustrated asset owners have started turning to cheaper hedge fund replicas, such as smart beta and risk premia strategies, which are far less expensive and more liquid.

Smart beta funds are typically exchange-traded funds that use a factor other than market capitalisation to invest, such as dividend returns or a low level of volatility. Because the ETFs are passively managed they are far cheaper than hedge funds – often costing around 50 basis points a year.

Similarly, alternative risk premia strategies are designed to capture well-known market risk premiums (momentum, volatility, value, etc.) using a quantitative, structured approach.

Of course, some strategies have performed consistently well over time, but that of course makes them harder to access as they attract more demand. In addition, often the bigger a hedge fund gets, the less likely it is to perform well. And the increasingly tough investing environment is making it more difficult for even the smartest and most nimble traders.

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