evestment: The evolution of hedge fund investing Institutions evolve investments at varying speed The challenges of manager selection and fee pressure

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1 April 2015 evestment: The evolution of hedge fund investing Institutions evolve investments at varying speed The challenges of manager selection and fee pressure Guide to strategic direction of asset flows in 2015

2 The evolution of hedge fund investing & why institutions remain sanguine By James Williams The ripple effect that followed last year s announcement that CalPERS was exiting the hedge fund space can still be felt. This was, after all, a major US public pension plan with an estimated USD4bn in hedge fund assets. Why the volte-face? Would this lead to a mass exodus? How worried should managers be? It certainly threw up a number of questions. But despite recent news, in January, that PFZW, a Dutch pension plan, was also divesting its hedge fund portfolio there is no reason to suspect that institutions have suddenly lost faith in this sector. Indeed, for many, it remains a vital tool in their portfolios. I think pension funds will continue to increase their allocations to hedge funds this year. One of the biggest misconceptions is that they are using the S&P 500 as their benchmark for a diversified hedge fund portfolio. I think very few pension funds do that, says Don Steinbrugge, Founder of Agecroft Partners LLC, a global hedge fund consulting and marketing firm. They are either comparing their hedge fund portfolio to a particular hedge fund index or using some form of targeted forward-looking return expectation for their hedge fund portfolio, which is something in the 4 to 7.5 per cent range. In its 13th annual Alternative Investment Survey, Deutsche Bank forecasts that global hedge fund assets will grow a further 7 per cent this year. The report writes: Institutional investment in hedge funds is set to increase, Peter Laurelli, Vice President of Research at evestment with 39 per cent of these investors planning to increase their allocation to hedge funds in Jennifer Bishop is Head of Macro/ Absolute Return and Alternative Credit Research at Towers Watson, a Londonbased hedge fund research and consultancy firm. When asked whether hedge funds are suitable for mega institutions she notes that it depends on each institution s investment beliefs and governance structure. Manager selection, getting the right concentration of managers and mix of strategies, agreeing on the right fees and liquidity terms: these are all key considerations. We continue to believe that a small subset of the hedge fund universe represents a good way for institutions to access manager skill, which is key in constructing a diversified portfolio to achieve risk and return targets, says Bishop. evestment is a leading data, analytics and market intelligence provider to the institutional investment community. According to its 2015 Hedge Fund Industry Outlook report, published 30 December, 2014, net asset inflows into hedge funds this year could be between USD90bn and USD110bn. As Peter Laurelli, Vice President of Research reveals, from 2010 through to the present time, approximately USD280bn of new assets have entered the space. The bulk of those assets have come from large institutions who suffered considerable losses in the wake of the financial crisis. This prompted a re-visit of their investment evestment Report Apr

3 guidelines and a realisation that to present instances of large losses while maintaining market exposure, they needed to consider alternative investment strategies. The primary driver of inflows has been a continuing decline in interest rates in fixed income and credit markets and rising equity market valuations. Money has rotated out of long-only US equity and fixed income assets as investors look for alternative ways to allocate that capital. This has benefited US long/short equity and long/short credit funds. In the last two years, for example, we ve seen USD95bn go into alternative credit strategies and USD85bn go into equity long/ short strategies. There are other areas of the traditional long-only space where we see desire for flexible global exposure. We track a global balanced tactical allocation universe and in recent years this has emerged as a place of interest for investors. In the last two years we ve seen USD70.4bn of net inflows, explains Laurelli. With information on over USD22tn of traditional, institutional assets and over USD2tn of alternative fund assets reported into its datasets, evestment is well positioned to get a handle on how institutions view hedge funds. The firm sees a considerable amount of information on new pension plans either entering the hedge fund space for the first time or increasing their allocations to managers. In Laurelli s view, the CalPERS decision was very much an anomaly. Their operations appear very much in-house and the decision they had to make was if they were going to invest in hedge funds in a scale that made sense, they would need to invest a meaningful amount of time, resources and capital and that did not fit with their focus on keeping expenses low. There are plenty of large institutions successfully managing direct investments in hedge funds, says Laurelli. The attraction of investing in hedge funds is that they give institutions the ability to gain alternative types of exposure. Take the credit long/short space, for example; there are opportunities to generate 7, 8 per cent (as a ballpark figure) that pension plans are struggling to generate from their long-only fixed income portfolios. As Laurelli notes, European distressed credit and special Jennifer Bishop, Head of Macro/Absolute Return and Alternative Credit Research at Towers Watson situation funds have done well and offered attractive returns to investors in recent times: Distressed funds with either a focus on European assets, or the ability to operate in European distressed markets returned an average of nearly 5 per cent in 2014 when the average distressed fund returned only 1.35 per cent and the hedge fund industry as a whole returned 2.22 per cent. In the last three years, these funds have produced an average annualised return of 9.90 per cent. What institutions have to be mindful of, however, when they first allocate to hedge funds, is what their reasons and expectations are from the outset. Too many investors view hedge funds simplistically as a way to beat the markets. As their level of understanding and awareness of how to use them improves, the more closely aligned institutional investors interests will likely become with the managers they select. Some institutions are willing to take concentrated positions and accept greater amounts of volatility for potentially higher returns. Others might be looking for very flexible global exposure, maybe in macro and managed futures strategies, suggests Laurelli. There is a trend for some pension funds to put together a portfolio of hedge funds that have low correlation to longonly benchmarks and for those investors there is strong demand for global macro, CTAs, equity market-neutral and other types of low correlated strategies, according to Steinbrugge, who adds: For pension funds that view hedge funds as best-of-breed managers and incorporating them into different asset classes across their existing portfolio (rather than viewing them as a distinct asset class) there is continued demand for structured credit, distressed debt and other types of fixed income strategies that will outperform their long-only fixed income allocation. Multi-stage evolution The above comment by Steinbrugge illustrates the fact that pension funds are at different stages of evolution when it comes to hedge fund investing. The majority view hedge funds as a distinct asset class separate from their wider portfolio. This is stage one. The main evestment Report Apr

4 objective here is to build out a diversified portfolio, typically by investing into Fund of Hedge Funds (FoHFs). Stage two is where pension plans still view hedge funds as a separate asset class, but choose to invest directly, typically with large managers with well-established brands; this is the stage most pension funds are at today. As they build out research staff and their knowledge of hedge funds, stage three involves moving away from large managers and building out their allocation to alpha generators. These tend to be smaller sized hedge funds. The final stage is where they view hedge funds as best-of-breed managers and incorporate them into different asset classes, explains Steinbrugge. Bishop says that it makes sense for investors to approach hedge fund investments without bucketing where possible: For example, when considering investing in credit, depending on the client s beliefs and risk/return targets, as well as the stage in the cycle, it may make sense to look across traditional credit, illiquid credit and hedge funds to find the best manager line up. The challenge of manager selection Regardless of what stage of evolution pension funds are at, manager selection is one of the most important aspects to hedge fund investing. Whether they use consultants, multi-manager specialists, or rely on internal research teams, long-term confidence in the managers they partner with is a key factor. This might not simply come down to performance. Of equal importance is trust and having a clear line of communication with the manager. Large established managers still dominate institutional inflows and whereas some still represent attractive investments others have perhaps over-reached in terms of asset levels and are facing capacity issues or other things have changed in terms of people, process and risk appetite since the early days of their track record. For large investors needing to deploy large amounts of money, often large managers must be considered or other investment options outside of pooled funds; for example, managed accounts, stakes in management companies or co-investments, says Bishop. Industry growth (US$bn) $3,250 $3,000 $2,750 $2,500 $2,250 $2,000 $1,750 $1,500 $1,250 Q4 10 Q4 11 Q4 12 Q4 13 Q4 14 Total assets (left) Net investor flows (right) $400 $350 $300 $250 $200 $150 $100 $50 Indeed, Steinbrugge comments that one of the challenges of allocating to the largest managers is that some of them are managing more assets than their strategy can optimally manage. This is causing a dilution of performance. There are various reasons why larger managers, on average, underperform smaller managers. Firstly, the alpha they generate through security selection is diluted across a larger asset base. Secondly, with some managers there is a reduction in motivation once their income and net worth rise significantly. There is also an incentive among larger managers to reduce risk in the portfolio to maintain assets and increase the probability of collecting a management fee from their client base, states Steinbrugge. When looking at smaller managers in consultation with its institutional clients, Bishop says that the investment team and operations have to meet certain standards to ever be considered. For us, it is about finding managers small enough to represent interesting alpha opportunities but are sufficiently well built such that we are comfortable our clients are not taking too much business risk. Most investments tend to be in funds sized between USD1bn and USD3bn, according to Bishop. The bigger and more sophisticated the institution, the more likely it will have the internal resources needed to select its own managers. But in terms of a new entrant $0 evestment Report Apr

5 looking to reduce their long-only exposure this is not really a viable option. Better for them to use a consultant to select an appropriate group of suitable managers, to invest with a FoHF manager or perhaps a multi-strategy fund to meet their specific needs. For other institutions, they might be looking for a unique type of exposure to a specific market maybe they want to increase their exposure to Europe and explore opportunities in alternative credit strategies as banks repair their balance sheets. They have a clear top-down approach, which helps narrow the manager universe in a meaningful way, comments Laurelli. Of course, institutions that construct concentrated portfolios are under a lot more pressure from trustees and investment committees to generate good performance. It s a higher risk strategy and one that perhaps didn t work at CalPERS. That s when tough questions have to be asked: is it time to increase the overall allocation and select a new series of investments or make a tactical retreat? The fact that institutional assets continue to flow in to the hedge fund industry suggests that pension plans are willing to keep the faith. Moreover, as their track record and depth of experience builds, institutions will, over time, invest more with smaller managers. This is a trend that happened in the long-only space in the US back in the 1980s when institutions shifted from the largest managers to more niche players. What will drive them towards doing that is simple: to enhance the risk-adjusted returns in their portfolio, suggests Steinbrugge. Fee pressures To continue the comparison with the traditional space, Laurelli is quick to point out that long-only managers face their own questions over fee structures as investors assess the value of active versus passive management. Where hedge funds come under more pressure, however, is the fact that they are designed to offer something unique. When a particular strategy fails to deliver, the fee structure becomes a more magnified issue. This is not helped by incidents such as the CalPERS and PFZW exits, or indeed by the rising prominence of more cost-effective liquid alternative products. Historically hedge funds have been able to charge the size of fees because of the value they ve given to investors. As the industry has become bigger, if a manager is not able to differentiate their approach then fees are going to remain under the spotlight, says Laurelli. Some managers still charge 2/20 and can justify this through limited capacity and strong alpha generation. Generally, though, the days of 2/20 are over. Few managers evestment Report Apr

6 can justify this and few investors are willing to pay. Whilst headlines such as CalPERS do place pressure on the industry, overall assets invested in hedge funds have continued to increase, says Bishop. Multi-strategy, equity and credit inflows So where might those assets by headed in 2015? According to evestment s research report, there will continue to be flows into equity-focused strategies (event, activist, long/short), albeit to a lesser degree than Laurelli says that the reason institutions will keep allocating to hedge funds is partly in response to stock market growth. Over the last couple of years the S&P 500 has returned over 50 per cent and this is leading to toppish markets and question marks over fair valuations. It s not a coincidence that over the last two years we ve seen over USD400bn come out of long-only strategies focused on US equity markets. It s primarily due to a redistribution of those gains. Although that is a fraction of total assets in that space, if even a small amount of that comes over into equity long/short that s a meaningful inflow. Between 2012 and 2013, USD400bn came out of actively managed US equity strategies and in 2013 and 2014 a total of USD85bn flowed into US equity long/short strategies. Redemptions out of actively managed US equity funds continued in 2014 and we expect capital to continue to get reallocated to the alternatives sector in 2015, says Laurelli. The same applies for fixed income as institutional investors look to allocate more into credit long/short. This is likely to be a more nuanced approach as credit strategies generated a string of negative returns towards the end of Where investors may focus their attentions, says Laurelli, could be in distressed strategies (which attracted USD9bn of inflows last year) and special situation strategies where opportunities are beginning to present themselves in certain market segments such as US energy, and, more broadly, Europe. Multi-strategy funds have enjoyed continuous net inflows over the last two years. At the same time, we ve seen quite a lot of outflows from the FoHF space in the last three years, however flows showed some stability in 2014, observes Laurelli. One thing we ve noticed with investors is that they are becoming more comfortable investing directly into hedge funds. While we ve seen FoHF assets decline, at the same time we ve seen multi-strategy asset inflows increase on a consistent basis. It gives diversity of hedge fund exposure in a single investment, which might appeal to new institutions or those that are moving away from FoHFs to get direct exposure. This chimes with the evolutionary cycle Steinbrugge refers to earlier in this report. According to Laurelli, prior to slight inflows in 2014, FoHF commingled products had experienced redemptions over the prior three consecutive years. Indeed, multi-strategy funds could be the flavour of the year, with evestment estimating USD48bn of inflows; up slightly on USD44bn last year. One interesting point to note is that across the industry, if you aggregate inflows in the December and January period, and the June and July period, you tend to have the lowest inflows. Over the last four years, those two periods either have outflows or the lowest inflows for the whole year. The multi-strategy space, however, has not experienced that trend. Their flows have been remarkably consistent over the last two years and in 2015 inflows are already above average, confirms Laurelli. There are many reasons to suspect that as institutional investors deepen their knowledge of hedge funds and explore different ways of accessing them be they through funds-of-one, managed accounts, or even by accessing liquid alternatives overall assets will continue to grow. Yes, some institutions will vacate the premises. But with precious few viable alternative alternatives, the vast majority will continue to forge ahead and evolve. And, eventually, start to show more faith in smaller alpha generating talent. We expect to see more inflows into hedge funds from institutions who continue to search for alpha, particularly as beta decisions become less obvious at this stage of the cycle. At the same time, fees need to continue to change as does flexibility in how to access hedge funds different vehicles, different fee structures, UCITS, managed accounts and co-investments, concludes Bishop. n evestment Report Apr