A recent white paper I read from Willis Towers Watson (Willis) suggests that the level of alpha and the volatility of alpha are at their lowest levels. The paper – Hedge Funds: A New Way – ultimately goes on to make a positive case for why hedge funds remain integral to investors’ portfolios but it is interesting to think, for a moment, as to why alpha levels are so low.
A recent white paper I read from Willis Towers Watson (Willis) suggests that the level of alpha and the volatility of alpha are at their lowest levels. The paper – Hedge Funds: A New Way – ultimately goes on to make a positive case for why hedge funds remain integral to investors’ portfolios but it is interesting to think, for a moment, as to why alpha levels are so low.
The data set used by Willis Towers Watson covered a period from 1993 to 2018. It found that the highest levels of rolling monthly alpha occurred between 1993 and 1998, while the lowest occurred from 2012 to 2018. Is this part of a longer-term trend of subdued returns as public markets continue to shrink? Or, like all financial markets, is this a temporary cycle that hedge funds will break out of?
I spoke to one of the authors of the paper, Sara Rejal, Head of Liquid Alternatives at Willis Towers Watson, to get her thoughts. “When we plotted the results,” she said, “we discovered that actually it does look like over time the amount of alpha has been reducing. That’s when hedge funds start to get challenged: when they can’t deliver what it is they are meant to deliver. We know the macro environment has been challenging but what else might be causing the problem?”
A number of structural headwinds were identified by Willis to try to explain the muted performance, the most important, in my view, being the reference to managers placing too much emphasis on enterprise risk. The inference here is that hedge fund managers have reduced the amount of market risk they take (and thereby volatility) because they don’t want to scare off investors, and have instead focused more on maintaining their management fees. The net result is lower returns and lower expectations.
This is a broad observation and in no way represents the performance profiles of individual hedge funds, many of which have delivered eye popping returns for their investors; one only has to look at Two Sigma, which has generated USD15 billion in net gains since inception, to appreciate this.
But if, as the Willis paper suggests, investment risk has been on the slide, one cannot overlook the tremendous maturation of the hedge fund industry over the past decade and the effect this has had on how managers run their strategies.
Panayiotis Lambropoulos is a Portfolio Manager of Hedge Funds at the Employees Retirement System of Texas. Speaking to him last week, he told me that part of this low performance narrative is related to what he called ‘allocator beta’.
“Following the GFC, there was a swift reaction among hedge fund investors,” he remarked. ”They looked at which hedge funds were able to perform, or at least preserve capital, between ’07 and ’09, and went for the biggest, most established managers; the Google’s and IBM’s of the hedge fund world.
“The constitution of the investor base changed from being 50 per cent FoHFs and family offices to perhaps 10 per cent, with pension plans going from 0 per cent to 40 or 50 per cent. You’ve therefore seen this shift of risk tolerance as managers look to appease their investors.”
Rejal said the enterprise risk factor “was of particular interest to us and something that we could focus on more with managers”, (in respect to how Willis builds its hedge fund solutions).
“We first approached larger hedge fund managers assuming they would be better placed to offer a suite of solutions, and what we found was they were the most resistant to changing. They were sitting on large amounts of assets and generating very high revenues from their flagship funds and they didn’t want to shake that up too much.
“There needs to be different return drivers and higher amounts of risk used, in order to achieve the desired outcome, and the strategies themselves need to be less commoditised. It’s not to point the finger at anyone, but ultimately we’ve ended up in this situation where managers who are a bit too conservative is not enough for us.”
Willis believes that to optimise hedge fund performance, it is necessary isolate the specialist skills possessed by a manager and to avoid generalist multi-strategy funds, in order to design new, creative mandates that pass muster.
Rejal told me that because of the complexity of their infrastructure and size of their portfolio teams, it is often hard for large multi-strategy funds to justify lowering their management fees.
Willis’ approach is to collaborate with the right kind of managers to design customised solutions for its hedge fund portfolios to shift the focus back from enterprise risk to investment risk in order to then target an appropriate risk profile.
“We say to managers that if it’s not in their skill set to handle the infrastructure and operational demands of running carve-outs (and bespoke mandates) they should simply outsource them. There are some things we don’t like to tolerate, such as research costs: we don’t think these should be passed through as a fund expense. That’s been our philosophy long before MiFID II came along.
“If a manager is unwilling to do that, we would look to set up our own mandate where we can control that kind of expense,” Rejal explained.
Carve-outs are not a new concept but perhaps they are becoming more relevant as consultants, pension plans and sovereigns seek to juice the returns from their hedge fund allocations. Emerging managers are an ideal gene pool to conduct such an experiment, as they are invariably more likely to work with early-stage investors for mutually beneficial purposes.
Lambropoulos confirmed that ERS has customised solutions within another part of the trust, called ‘directional growth’. “All relationships within that allocation are called short extension strategies i.e. 150/50 and 130/30 structures and performance fees are only paid on outperformance versus the pre-agreed upon benchmark.
“Those solutions are, however, the exception rather than the norm. Carve-outs and customised solutions are only a part of how we allocate to hedge funds.”
In his view, if investors engage early enough and get to know a manager’s investment DNA, it can give them access to data to dissect the source and quality of performance. “Then, further down the road, it can put you in a better position to explain to the manager ‘This is what we’ve analysed and identified so what if you did X, Y, Z?’
“That way we can invest with the manager on a foundation based on real data and insight,” said Lambropoulos.
This reaffirms the point that when it comes to hedge fund investing, it is still very much an art – seeking out those hidden gems to back early in their management careers. But technology is now a way to introduce a degree of science to the endeavour.
“In terms of technology, I’m a big believer in it,” remarked Lambropoulos. “For institutions like ERS, it behooves us when introducing different conduits to utilise technology as much as possible to get a sense of what the true underlying risks are in the portfolio, on a true look-through basis – regardless of whether these are traditional or alternative assets.”
It could have been easy for Willis to tell its clients that they didn’t need hedge funds at all, that they are too much of a headache and there are many other ways to diversify their portfolios.
“But we truly do believe there is a lot of talent in the hedge fund space, and that unconstrained portfolios can deliver a lot of alpha,” said Rejal. “It’s just the way we extract that alpha has to change. Going straight into constrained, flagship funds is not the way for us to do it.
“The message we are conveying to investors is that if they are even slightly concerned about markets, then they need to make sure they have a hedge fund allocation.”
