Meeting performance expectations is the number one challenge facing institutional hedge fund investors in 2012. At least that’s according to SEI’s fifth annual global survey entitled: The shifting hedge fund landscape: Part I of II, which the US firm conducted in collaboration with Greenwich Associates. Senior investment professionals from 105 institutions took part in the survey, the majority of whom (85%) were based in the US.
2011 was the second-worst year, performance-wise, for hedge funds: the average global fund was down 5%. Although the survey found that three of the four primary objectives for hedge fund investors related to risk management – non-correlated investment strategies (22.4%), diversification (21.4%) and decreased volatility (12.2%) – performance came out as the top challenge they faced (25.9%).
“It’s a case of managers having to be transparent about their portfolios, but also about their investment philosophy, investment approach and investment process. The portfolio holdings then support those: it’s a tiered process. The better the investor can understand what the manager is doing, the more faith that manager is going to have that that investor is going to stick around through cycles and not bolt at the first sign of underperformance,” explains Ross Ellis (pictured), Vice President, Knowledge Partnership, Investment Manager Services at SEI.
The last thing an investor like CalPERS wants to do is have to rotate across managers and keep having to perform lengthy due diligence. However, volatility and downside risk are a function of performance. Ellis says he didn’t expect performance issues to come out on top.
“When you hear investors saying ‘I want you to focus on risk management, I’m worried about downside risk’, then this seems somewhat dichotomous. The manager will be thinking ‘What do you want from me?’” says Ellis. “Investors should have learned that you can’t separate performance from risk management.”
David Mumford, Director of Research at the Knowledge Partnership, Investment Manager Services at SEI states that this is the first year there’s been a major change in investor sentiment, noting that transparency was the key concern over the last few years. “Now people are seeing that performance has changed, they’re putting ’08 behind them – when immediately afterwards they made it clear that what they wanted most of all was transparency, liquidity etc – and going back to their original thinking, which is: I want performance, but by the way you can’t turn back the clock.”
Investor sentiment towards the importance of hedge fund managers was mixed in the report. It found that there was a 41%-to-25% margin on whether they could meet their return objectives without having hedge funds in their portfolio. One thing the report stresses is that managers need to clearly articulate their investment objectives.
“The questions is, are managers delivering what investors want or what they think investors want?” posits Ellis. “Historically, managers were loathe to provide any information, it was an exclusive club. Then investors started to say: ‘I want you to give me x, y, z’, which managers did. The market continued to evolve with institutions wanting more information. Managers go away, deliver what they’re being asked for by investors, by which time they’re asking for something else. It’s a constant evolution, a sort of perpetual motion. That’s why we chose Newton’s Cradle as our cover image – we think it’s a very apropos image,” says Ellis.
This emphasis on not only clearly communicating with investors from the get-go, but, critically, maintaining a continuous dialogue with them applies to managers of all sizes. For emerging managers though, being effective at raising assets depends on what Ellis refers to as being able to “demonstrate they have a better mousetrap: whether it’s portfolio management, level of transparency or the ability to articulate the strategy effectively.”
Thirty per cent of investors in the survey cited absolute return as their number one objective, up from 21% last year. As the report rightly states, managers need to be clear with investors, some of whom might consider AR as meaning “never losing money” whilst others might understand it as “losing less than long-only managers”. This suggests that managers need to do as much due diligence on potential investors as investors do on managers in order to understand the DNA of their risk/return profile.
If you consider that the next three objectives for investors were all risk-related – non-correlation, diversification and decreased volatility – then perhaps investors should be lowering their expectations when investing in hedge funds and accept that shaving off performance to better protect downside risk is an acceptable outcome.
Ellis comments: “We’ve always found that losses were less acceptable to European investors than US investors even if performance was better than an index or long-only funds. The survey results do show that risk mitigation is high on the list, at this moment, but if returns overall start to slow and investors can’t meet their liabilities they’re going to be looking for the saviour managers, the uber-alpha.”
This is understandable and feeds back into the earlier point about investors wanting performance. “Investors want transparency, lower fees and liquidity, but they also want great performance,” says Mumford.
Clearly then, there’s a degree of conflict as to what investors really want in this report. “If I’m an institution that has to pay out 8% annually, for example, I need 10%. But I also need risk management. Investors are saying ‘You guys are the smartest on the planet, find me a way’,” adds Ellis. With absolute return, investors can only afford to lose so much of the upside. It’s just another added pressure on managers to perform.
As for the strategies most favoured by investors, long/short equities, event-driven and credit strategies came out on top, attracting 82%, 53% and 42% of the votes respectively. By comparison, special situations, market neutral and CTAs only received 15%, 13% and 8% of the votes.
“I’m a little surprised special situations and market neutral strategies are as low as they are,” says Ellis, who concedes that with regards to CTAs, they’re perhaps better established and more well known to European investors.
Various commentators are bullish on the capital raising/re-allocation opportunities in 2012 and the SEI report would seem to reinforce this. It found that whilst those planning to increase their allocations was 38% in 2012, down on 54% in 2011 but nevertheless a positive figure, the average allocation to hedge funds was up around 1%: 17.8% compared to 16.7% last year.
“2012 could be a great year for managers seeking new investment because there’s going to be new money and re-allocations going around,” comments Ellis, with Mumford adding: “Although 16% of survey respondents plan to decrease their allocations from the previous year, the number of respondents not changing has actually increased by 12%, which I believe reflects a continued commitment to hedge funds.”
As for Fund of Funds, the survey found that 40% of investors invested directly in single-manager funds, up from 24% in 2010. But Ellis does not think this signals the death knell for FoFs: “While HFR indicated that over USD7billion flowed out of FoFs in 2011, we’ve also seen FoFs being launched that are focused on emerging managers. A large investor might not be able to invest in a new exciting manager (because of concentration risk) but they might invest in a FoF of 10 new managers.”
Ellis says that FoFs have had to change who they are and that as long as they continue to evolve, they’ll remain relevant.
“In order to survive they’re expected to change their m.o., provide more education and excel in asset allocation, risk management, manager selection, benchmarking etc,” says Ellis.
As to what the report’s key takeaway is, Ellis asserts: “It’s that investors are becoming more vocal in communicating what they want. They are more in control now.”
