Hedge fund inflows face turning point

Hedge fund inflows face turning point

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Ripples of dissatisfaction have been spreading through the pensions world since early September, when the California Public Employees’ Retirement System (Calpers) announced it is to pull its entire $4bn hedge fund allocation. More than a few of its peers are now reassessing their own investment strategy. 

The second-largest pension fund in the US put its decision down to “complexity”, “cost” and a “lack of ability to scale at Calpers’ size”. Across the pond, London Pension Fund Authority pulled out of Brevan Howard in June, citing “disappointing” results, its failure to disclose exposures and “unjustifiable” fees. The Dutch pension fund PMT exited in September, largely due to costs. 

So far there has been no exodus, but there are indications of a marked slowdown in fresh allocations. While Hedge Fund Research (HFR) notes that total assets in Q3 2014 of $2.82trn was the ninth consecutive quarterly record total, the pace of inflows is slowing. Just $15.9bn of new capital was allocated in Q3, a significant decline from the $30.5bn of inflows during Q2, and well below the $23bn of Q3 2013. 

Figures from Eurekahedge are even more downbeat, suggesting that hedge funds are experiencing a fourth consecutive month of net outflows, with investors redeeming $20bn since August, trimming year-to-date net asset inflows to $55bn. 

The extent to which other pension funds are thinking along the similar lines – the Teacher Retirement System of Texas and the UK’s Railways Pension Scheme are all reviewing their allocations – will become clear in the coming quarters as the significantly- lagging data emerges.

Unfortunately, the early signs are not good. An EY survey showed that in North America and Europe, investors decreasing allocations outweighed those increasing by approximately 25%. Only 13% of institutional investors planned to increase their allocation to hedge funds in the next three years. 

High fees, low returns 

Is it reasonable to think that we might be reaching a turning point? Discontent over high fees and poor returns has certainly been brewing for some time. Only 19% of US investors said hedge funds were worth the fees, despite the fact that there is widespread evidence of fee erosion over the past few years, bringing down the “two and 20” fee structure closer to 1.5 and 18. 

A Pyramis survey conducted over the summer showed that 31% of institutional investors in the US said hedge funds were the least likely asset class to meet performance expectations. 

A Preqin survey showed that 59% of institutional hedge fund investors were looking mainly for reduced volatility and just 7% were more motivated by high returns. If hedge funds satisfied the demand for low volatility and diversified returns, they would justify their fees despite meagre returns – the problem is that they have not fulfilled even this for some time. 

Research by Vanguard, a manager of low-cost funds and exchange traded funds, showed that most hedge fund categories failed to provide significant diversification beyond that of a 60:40 portfolio of stocks and bonds over the course of the financial crisis.

Likewise, a study by IPAG business school found there were “significant correlations” between hedge funds and the stock market. Matters have not been helped by the fact that hedge funds have severely underperformed the S&P500 since the beginning of the year. It is an unfair comparison – hedge funds typically aim to deliver absolute returns, not necessarily high ones – but it provokes uncomfortable questions in the light of Vanguard’s research. 

The cost of selecting and monitoring hedge fund allocations compounds the problem. Calpers noted that they were simply “too complex”, taking more time to administer than was justified given that hedge funds cannot be scaled to a meaningful size for the mammoth fund. 

Bright side 

However, this turnaround should not worry the bulk of good hedge fund managers. Many institutional investors, particularly in Europe and Asia, are sticking with hedge funds or even increasing their allocations. Asian private sector pension funds have increased their investment in hedge funds from 13% in 2013 to 15.7% in 2014, according to Preqin. 

This could be explained by different priorities for pension schemes across these regions. Those in the US most commonly – 28% of respondents – cite their funding status as their top priority, so would naturally be drawn away to rapidly-rising equity markets. 

Conversely, European investors were most concerned about the low-return environment (26%) and volatility (26%) and Asian investors most about volatility (23%), risk management (21%) and the low-return environment (18%). Such institutional investors are more likely to be attracted by hedge funds that confidently offer stable 4% to 7% returns with a low risk profile, increasingly so when rising interest rates may start squeezing bonds values. Demand should be strong, at least until Europe and Asia follow the US into a period of sustained growth. 

Whether Calpers’ decision turns out to be a catalyst or not, it seems that hedge funds will find investment from some quarters tailing off. This may benefit pension funds, putting them in a stronger position to negotiate on costs and demand more tailored products. It may also have a positive impact on the hedge fund industry. 

IPAG’s study suggested that the growing weight of hedge funds assets is one of the reasons they have become increasingly correlated with the stock market. With less money to manage, hedge funds could become more nimble and regain their ability to exploit market inefficiencies.

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