Hedge fund allocations start to revive as Covid-19 crisis proves industry's worth to investors

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Investor allocations to hedge funds have fallen for the third consecutive year – but the industry’s ability to weather economic turbulence and market volatility through active management will continue to attract investor attention, according to two new industry studies.

EY’s 14th annual ‘Global Alternative Fund Survey’ quizzed alternative investment managers and investors on a range of topics, including portfolio performance, allocation plans, and the impact of the coronavirus pandemic, as well as ESG and other investment trends. It found that although hedge fund strategies have shrunk as a proportion of investor portfolios, their impressive outperformance during 2020’s Covid-19 crisis has not gone unnoticed.

Preqin’s ‘Future of Alternatives 2025’ study meanwhile suggests that despite outflows, hedge fund AUM will surge over the next few years, driven by actively-managed strategies overcoming higher volatility environments.

EY’s annual study shows allocations to hedge funds now make up just under a quarter (23 per cent) of portfolios’ total allocations in 2020, a 10 per cent tumble from 2019, and sharp slide from the 40 per cent recorded in 2018.

Investor capital has been drawing away from hedge funds and towards other alternatives – such as private equity/venture capital, real estate and credit, which have seen positive inflows – while hedge fund flows have been net flat.

“Performance of these other asset classes has on average exceeded hedge funds for several years, causing a shift in the composition of each relative to hedge offerings,” EY said.

‘Increased interest’

Still, more than half (52 per cent) of hedge fund managers surveyed by EY reckon the continued coronavirus-driven market volatility will drive a “significant increased interest” in actively managed strategies.

“This trend is more pronounced with the largest hedge fund managers – those with over USD10 billion in assets under management – where over 75 per cent responded that Covid-19 will increase interest in active management,” the report observed.

Allocators tend to agree. Almost a third of investors expect to have a greater interest in active management going forward, while just 15 per cent anticipate having an increased interest in passive investments.

“The sentiment from both is buoyed by the initial performance returns from alternative fund managers where volatility created opportunities to outperform benchmarks and other passive offerings.”

The EY study interviewed a total of 237 managers, comprising 110 hedge funds and 127 private equity firms, and 73 investors, made up of funds of funds, pension funds, and endowments. Of the hedge funds surveyed, 64 were based in North America, 28 were in Europe and 18 were in Asia. 28 of the hedge fund firms managed more than USD10 billion, 45 managed USD2-10 billion, and 37 managed less than USD2 billion. The 73 investors interviewees collectively represented more than USD1.4 trillion in assets.

Exceeding expectations

The study noted that alternative fund performance has “shined” amid market volatility and global uncertainty, with managers positioning portfolios to minimise risk while at the same time capitalising on temporary dislocations

“During the peak market volatility in early 2020, on average, almost all alternative fund strategies significantly exceeded major benchmarks,” EY said, noting that the performance “did not go unnoticed by investors”.

More than half of those polled (58 per cent) said hedge funds met or exceeded performance expectations, compared with 42 per cent who said hedge funds failed to meet expectations.

“Hedge fund performance varied by strategy, but on average almost all significantly exceeded major benchmarks,” EY said. “When major indices were down 15-20 per cent in early 2020, many hedge funds were only down low single digits.”

The report also explored how the coronavirus pandemic upended working practices, with “all aspects of fund management” – spanning portfolio construction, investor engagement and due diligence, and talent acquisition and developments – facing constraints.

But it also acknowledged the resilience of hedge funds and alternative investment managers, who utilised changes in technology, automation, digitalisation and outsourcing to help deliver for clients.

“The strength in operations during this uncertain period has shined a light on future possibilities via enhanced investment and leveraging of data, technology and remote working capabilities, resulting in many managers re-imagining the future work environment,” EY observed.

Appetite for ESG (environment, social and governance) investments has almost doubled over the past year, with some 49 per cent of investors quizzed by EY now investing in ESG projects. However, the number of alternative managers offering those products has remained the same.

Separately, 70 per cent of investors believe an alternative manager’s internal ESG policy is “critically important” when deciding whether to invest, compared to just 27 per cent reporting this as critically important in last year’s survey.

EY’s findings also showed that despite diversity rising up the corporate agenda, just a quarter of hedge fund managers consider improving ethnic and gender diversity as a top-three priority.

Looking ahead

Meanwhile, Preqin predicts global alternative assets under management will top USD10.7 trillion by the end of this year, and will soar by 60 per cent to hit USD17.2 trillion by the end of 2025.

According to Preqin’s new ‘Future of Alternatives 2025’ study, which projects assets growth and trends across alternatives, global hedge fund assets will remain the second-larger alternative asset class – behind private equity  reaching USD4.23 trillion by 2025.

Though investor capital may drift towards lower-cost products such as ETFs, smart beta and other liquid alternatives, hedge fund AUM will be driven by performance, with active management overcoming higher volatility environments. Macro and equity strategies are expected to remain the largest hedge fund strategies in terms of AUM.

“The next five years look likely to pose more economic and financial market risks than the past decade,” wrote Julian Falcioni, senior research associate at Preqin. “Hedge funds proved their risk mitigation strategies through the pandemic-induced market crash this year, reminding investors why hedging is valuable.”