Australian investors show increased appetite for hedge funds

Australian investors are showing an increased interest in hedge funds after the sector demonstrated its robustness during the pandemic, and are now seeing how they could provide opportunities for protection against the spectre of inflation.  

This is the view of Scott Pappas, Head of Alternatives and Derivative Solutions at Frontier Advisors, an Australian investment consultancy that works with superannuation funds, endowments and liability-driven investment portfolios. 

According to Pappas, when equity markets were falling over consecutive days at the start of the pandemic, hedge funds typically held up well.  

“Some people criticised the fact that hedge funds didn’t mirror the recovery of equity markets when they bounced back as long and as hard as they did, but investors should be taking the more medium to long term view that alternatives can still play a powerful role in a portfolio,” he commented.  

This sentiment is echoed by UK-based AON’s investment consultancy branch. Alison Trusty, Associate Partner in private debt and hedge funds at AON, said that overall hedge funds performed well throughout the pandemic. They fulfilled their role of providing diversification, and AON’s clients feel that now is a good time to be taking on that risk.  

This is reflected in hedge fund performance numbers for last year, as 2020 saw hedge funds’ full returns finishing up by 11.05 per cent, according to research from eVestment, their best annual performance since the 2008 financial crisis.  

Investors advised by Frontier are also looking to specific hedge fund strategies, like merger arbitrage, as a way to protect their portfolios against inflation. Though downside protection against market volatility has always been part of the appeal of hedge funds, Pappas said that interest has shifted from protecting portfolios against equity market risk to minimising the impact of inflation.   

He commented: “Although it’s not our base case that inflation will blow up, there is a possibility it could, so we’re now thinking about how to better protect clients’ portfolios. 

“If we do get an increase in rates over time, then all of a sudden, long duration assets such as equity and infrastructure will suffer, so we’re thinking more about investments with shorter duration cash flows like merger arbitrage, or other convergence-type strategy where cash flows are realised over shorter time frames. 

“These strategies aren’t influenced by the same discount rates, so they could complement a portfolio in an environment where rates are going up.” 

Merger arbitrage strategies have gained momentum in recent months due to the increase in M&A activity after last year’s dip in deals during the pandemic.  

In the rush for portfolio diversification, however, not all investors are looking at traditional commingled funds. Pappas noted that the growth of Australia’s powerful superannuation sector, currently managing over AUD3 trillion, has led to some of these funds internalising and taking on more investment responsibilities in-house. This could mean developing a deeper knowledge and control of strategic asset allocation, all the way down to choosing single stocks.  

Pappas observed that this change has occurred over the last five to 10 years, and that concurrently Frontier’s advice has evolved from offering advice on strategic asset allocation and reviewing manager selection, to providing in-depth intel of how exposures are managed, and how hedging policies and overlays are constructed.  

ESG has also become an increasingly key concern for Australian investors. Pappas said that hedge funds have typically been a little behind in terms of incorporating ESG into their practices, and generally have prioritised the social and corporate governance side of things over the environmental.  

Research from bfinance released last April showed that out of 256 investors, only 13 per cent of large investors with more than USD25 billion in assets under management said that their hedge fund managers reported a high level of ESG integration in their investments. However, Pappas said Frontier is starting to see managers seeking out data to help them make more environmentally-friendly decisions, and has seen some interest recently in carbon derivatives.