A timely shift
- Most institutional investors are sticking with their current hedge fund exposure
- 20% will increase, 10% will decrease; but private equity is of greater interest
- A strategy rotation into blue-chip hedge funds is potentially on the cards
By Hugh Leask
More institutional investors are opting for private assets over hedge funds as a means of protection against prevailing macroeconomic headwinds.
Roughly three times as many institutional investors will increase their private equity exposure (55%) next year than they will add to hedge funds (20%), with more allocators also favouring increases in private credit allocations (30%).
Nevertheless, just one in 10 institutions actually intend to withdraw capital from hedge funds, with close to a third of institutions keen to maintain their exposure next year, as inflation and interest rate challenges remain high on the agenda.
Travis Williamson, partner and head of hedge fund research, Albourne Partners, says investors are looking for assets that are correlated with inflation, have return streams unrelated to economic activity, and that provide a hedge to the higher market volatility that inflation creates.
“Hedge funds are a particularly helpful asset class when thinking about the latter, as they are relatively liquid. Elsewhere we see continued focus on real assets, due to its inflation linked return profile.”
Meanwhile, an increasing number of market pros are now sounding the alarm on mark-to-market write-downs looming over private assets – and the potential fall-out on investor portfolios.
“Over the past few years, people have put a lot of money into private investments, semi-liquid or illiquid. The issue is that a lot of people are now over-exposed to the illiquid market, and a lot of those assets have not been marked down yet properly,” Patrick Ghali, managing partner and co-founder, Sussex Partners.
Industry practitioners explain that marks on private portfolios are typically delayed by a quarter or two, and so now private asset valuations are falling under closer scrutiny just as institutions are weighing up their allocation plans for 2023.
Ghali says: “You have two problems. One is that you have too much of an allocation to your private investments because everything else is down and they are stable. But the other problem is that they are probably not as stable, as they haven’t yet been marked down properly. We’re speaking to clients who are now getting capital calls. I think there is going to be a lot of issues here.”
With the potential for certain private assets to be marked down as much as 20%, in line with public assets, Ghali predicts a growing reluctance to allocate more money into illiquid strategies.
Against this potentially shifting backdrop, the biggest hedge funds are circling pension capital, with three-quarters of $1 billion+ managers looking to engage with public pensions next year and nearly 60% with private pensions.
“Many institutional allocators are still coming to an understanding of what their portfolio will look like after 2022,” Williamson says. “Given the decline in public equities, it’s likely they are overweight in private assets, which at large, haven’t experienced markdowns like public assets, and depending on where hedge funds are placed in their portfolio construct, this could impact investor reaction.
“Interest in hedge funds has increased, but given current allocation weightings, capital flows have not yet materialised.”
Reflecting on the hedge fund-private equity dynamic among institutional allocators, Darren Wolf, global head of investments, Alternative Investment Strategies at abrdn, points to the relative opacity in private equity compared with hedge funds and other alts.
“Private equity has done very well for a very long time among institutional investors – but with private equity you are outright long equities in which you do not have any liquidity. Hedge funds and private equity tend to complement each other nicely: when things are humming along, the markets are quiet, volatility is low, and companies are buying other companies – that’s a great environment for private equity. It’s more of a bull market-type of strategy.
“But on the flipside, during these types of cycles we have right now, hedge funds tend to outperform as things become more volatile,” Wolf observes.
Shifting the balance
With a strategy rotation into blue-chip hedge funds potentially on the cards among allocators next year, long-standing wrangles over liquidity, capacity, and fees are coming into sharp focus.
“The issue with discretionary global macro, as well as those systematic trading strategies which can take advantage of the increasing volatility and dispersion, is that they don’t have so much capacity,” says Robert Khoury, director of investor relations at multi-strategy quant-focused manager Varuna Technologies AG and former senior portfolio manager at Union Bancaire Privée.
“In terms of drawdown, the large hedge fund managers, which have AUMs of above $5 billion, have been outperforming smaller managers – but a lot of the best-known managers have restrictions in terms of capacity. Many of them are closed.”
Regarding the fee-liquidity dynamic, Marlin Naidoo says: “Allocators have historically wanted discounted fees and liquidity aligned to the liquidity of the underlying investments. Today the biggest demand is for the most expensive hedge funds that are extending their liquidity terms. On that basis, you can see that the balance of power is shifting to the manager versus the investor. For some institutional investors, if they weren’t necessarily able to meet those terms or pay those fees, they would often have stepped away. But now for the most part, this is what they want. This is where the new price point is, both from a liquidity standpoint and an actual fees standpoint.”
This article first appeared in Hedgeweek's December 2022 Insights Report, Investor Interest