SECTION 2
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Rising rates and an inflation squeeze are fuelling an increasingly downbeat economic assessment. For hedge fund investors, capital preservation is now critical.
- Most allocators surveyed believed the global economy would worsen in 2023
- Rising interest rates is their biggest concern, followed closely by higher inflation
- Investors tipped to shift from capital preservation to absolute performance in H2
By Hugh Leask
Hedgeweek
Investors are taking a resolutely gloomy stance on 2023’s economic prospects.
A clear majority (56%) of all allocators surveyed believe the global economy will worsen next year – vastly outweighing those who say it will remain similar (26%), and those who think the outlook will improve a year from now (9%).
“Just because the markets are down 20% or 25%, that does not mean they can’t be down further by another 20%,” observes Darren Wolf, global head of investments, Alternative Investment Strategies at abrdn, reflecting on the broader downbeat outlook.
He says the last decade offered “the perfect backdrop” for corporate earnings, particularly in the US, underpinned by low interest rates, low inflation, no geopolitical risk, no war, low commodities prices, and high globalisation.
“Every one of those things has now precisely turned on its head 180 degrees,” says Wolf. “If that was a tailwind for corporate profits when those factors were supporting them, then conversely, when those same factors are headwinds, we shouldn’t ignore their impact now, as well.”
Concerns
Allocators say the rising interest rate environment is now their biggest concern, followed closely by higher inflation. With the Covid-19 pandemic receding from view, and energy costs large priced in by market practitioners, the impact of the Russia-Ukraine war is the third main concern.
Industry participants say rising rates – a key issue in IR teams’ discussions with allocators – pose far-reaching questions for both investors and managers looking to navigate the dramatically-altered landscape.
“The biggest thing people will need to wrestle with is that interest rates are higher, and for the first time in a long time there is yield again,” says Patrick Ghali, managing partner and co-founder of hedge fund advisory firm Sussex Partners.
“For investors, this is now key. A lot of hedge fund managers need to think about how they will generate returns in excess of the risk-free rate in a higher interest rate environment. A manager who is only making 5% a year when investors can get that risk-free is probably not going to stay in business for very long.”
With that in mind, it’s little wonder that investment performance is now at the centre of investors’ priorities heading into 2023. On a ranking of 1-4, where 1 is the most important and 4 is least important, performance ranked as the main priority across all allocator types, with an average ranking of 1.1 across institutions, private wealth, and asset managers/FoFs. Liquidity and fees appear somewhat level in order of priority, with investors ranking them 2.5 and 2.9, respectively, in order of priority.
Performance focus
“Relative performance has been the priority in 2022, as opposed to absolute performance,” says Brooks Ritchey, senior managing director, co-chief investment officer, and portfolio manager at K2 Advisors. “For now, investors are focused on capital preservation. However, by early next summer, investors will refocus on absolute performance.”
Meanwhile, Jens Foehrenbach, chief investment officer at Man FRM, says liquidity risks remain “at the forefront of our concerns.”
“More than a decade of extreme monetary and fiscal policies has occasionally led to extreme volatility in asset prices, but now we are also seeing accompanying market fragility. This is clearly illustrated by September’s surprising and sudden volatility in UK government bonds, which prompted emergency central bank intervention in one of the safest and most liquid markets,” he says.
“In this environment, we must especially concentrate on risk managing our portfolios and identifying risks in our invested managers. That is an important part of how we intend to generate alpha for our clients next year. We will continue to avoid managers whose liquidity in stress scenarios is unlikely to meet the requirements of our portfolios. The value of liquidity is high.”
Engagement
Meanwhile, with ESG ranked fourth, are investors beginning to shun the drive towards responsible investing – a major industry trend in recent years – as performance and portfolio protection take priority?
New data published by bfinance suggests not. Its ‘Global Asset Owner Survey’, which polled almost 400 respondents accounting for $13 trillion in assets, found that despite macroeconomic challenges, 32% of investors are cutting portfolio carbon emissions, with a further 34% planning to do so. One-quarter of allocators are themselves targeting net-zero themselves, and 32% would be “unlikely to hire an external manager” not committed to net-zero.
Carl-Johan Brodowsky and Jonas Börjesson, co-heads of investor relations at multi-strategy manager Brummer & Partners, says ESG remains a prominent theme in investor due diligence discussions, both in Europe and, increasingly, the US.
“I don’t think there has to be a conflict between returns and having an ESG initiative implemented in the portfolio,” says Brodowsky. “It’s a demand from investors, and it’s crucial for performance.”
Börjesson adds: “There are always different discussions on how to implement ESG, whether it’s through engagement and activist strategies, or through exclusion. I’m a strong believer in engagement and that’s something that can add to alpha generation.”
Alignment
Meanwhile, close to half of all managers surveyed by Hedgeweek (48%) say investors have enquired about separately managed accounts in the past year, and more a third (35%) of managers have asked for discounted fee structures. Some 24% have received questions about co-investment opportunities, while 22% have discussed strategy carve-outs.
Ritchey says custom bespoke accounts, for both institutional and private wealth groups, is “the biggest asset growth area that we’ve seen over the last 18 months”, citing a number of pension fund clients who have sought tailored risk mitigation hedge fund portfolios to reduce equity and bond sensitivities.
“We’ve had a couple of institutional plans ask us if we would build and manage a risk mitigation strategy for them. It’s something we had not seen for quite a while. We look at their stock, bond, and private investment allocations and then work with them to build a custom-made portfolio that hedges out the market risks they wish to avoid,” Ritchey says.
“It does take a while to set up a bespoke account – it’s very collaborative, and you’re building a custom hedge fund product, so it takes maybe two to three months.”
Wolf, who describes abrdn as “very big proponents” of separately managed accounts, says a major benefits of SMAs is in allowing managers to focus on buying assets and managing portfolios.
“If you can reduce, or even eliminate, the risk of all the other things – operations, back-office, infrastructure – and have the manager focused on the asset management side, and improve the alignment of interest between allocator and hedge fund, then a separately managed account makes sense,” Wolf adds.
“What’s driving this is the continued maturity of the industry, and the overall recognition that there is no such thing as a one-size-fits-all approach to accessing your hedge fund exposure.”
This article first appeared in Hedgeweek’s December 2022 Insights Report, Investor Interest
