A new study written by the Strategic Consulting team, Prime Services, Barclays Capital reveals that Discretionary Macro, Equity Market Neutral, Equity Quant and Credit strategies are most favoured by investors as they seek to reduce their equity long-only exposure.
The study, called “Crossing Currents – 2019 Global Hedge Fund Industry Outlook”, involved surveying 298 investors with approximately USD5.7 trillion in total AUM.
It found that equity hedge funds, by end-2018, were down 7 per cent with alpha being responsible for about two-thirds of the losses and beta responsible for one-third. This was largely down to a deterioration in the markets in December but alpha losses began as far back as July 2018.
Commenting broadly on the study, Stan Altshuller, head of strategic consulting in the Americas, tells Hedgeweek: “The main thing I would pull out of the study is the hedge fund industry looks as though it is maturing and total assets under management have levelled off. 2018 was a tough year, where we saw net redemptions out of hedge funds but having said investors are not fleeing in their masses. The redemption was very small (USD35 billion), which is only about 1 per cent of total industry AUM, and nothing like the redemptions we saw in 2008 and 2009.
“We think there’s a lot of movement and reshuffling taking place as investors move to different strategies that are more aligned with their interests.”
Indeed, when one looks at strategy net flows since 2016, an interesting bifurcation trend has played out.
In short, systematic strategies have enjoyed inflows while more discretionary/fundamental strategies, with a higher beta correlation to the markets, have fared less well. Equity market neutral/quant funds come out on top, attracting USD23 billion in assets. Fixed income relative value, merger arbitrage, systematic macro and credit also attracted inflows.
By contrast, equity long/short strategies saw USD78 billion of net outflows. Discretionary macro, activist/special situations and multi-strategy also incurred losses.
“It might not be a huge surprise for people to see outflows from equity l/s, it’s been the same for quite a few years; equity strategies used to account for over half of all hedge fund strategies but now they account for less than half. It’s therefore not necessarily an outright directional view on equity long/short, it’s partly because there are more strategies to choose from.
“The data points to interest among investors shifting more to systematic strategies. They are allowing more room in their portfolios for lower net biased, alpha-generating strategies such as market neutral and merger arbitrage, which wasn’t the case a few years ago,” comments Altshuller.
In the study, the authors remark that it appears investors’ 2018 behaviour (which strategies they allocated to and which strategies they redeemed from) is not a function of the 2018 performance of those strategies, but of their long-term performance. That is why, by and large, investors behaved consistently in the past three years while performance across strategies was quite different.
Since 2010, merger arbitrage was found to be the highest performing alpha generating strategy, returning 2.6 per cent (annualised). Moreover, during the most recent hedge fund drawdown period, between second half of 2015 and Q1, 2016, merger arbitrage had the lowest drawdown, at just 0.3 per cent. Fixed income RV also did well, generating 2.5 per cent alpha.
“Investors are looking at lower beta strategies and merger arbitrage is right at the top of the list, offering good risk-adjusted returns. By comparison, equity l/s and discretionary macro managers had drawdowns of 4 to 7 per cent and generated negative alpha of -0.4 per cent and -0.5 per cent respectively for the analysed period,” adds Altshuller.
One might expect the allocation outlook to remain supportive of these low beta strategies in 2019 but a surprise finding emerged out of the study; namely that discretionary macro, alongside distressed credit, came out as one of the most preferred diversification strategies not currently featuring in investors’ portfolios. Sector-specific equity strategies are another preferred option.
“Discretionary macro was the one big outlier that we found in the study,” remarks Altshuller. “Interest in this strategy seems to have flipped for 2019. Some 22 per cent of investors in our study cited this as their preferred strategy for portfolio diversification. Still, the interest does not always immediately translate into capital allocation, as we have seen similar interest in the years prior.”
One needs to take this with a grain of salt, though. This is only one study. It’s not representative of the entire industry. Still, investors are seeing volatility come back, they are seeing a shift in the regime not just in equities but all assets, and they are deciding that discretionary macro could be a way to go to generate uncorrelated returns in such an environment.
The study also found that investors have been broadly consistent with their targeted return expectations, ranging from 7.4 per cent in 2017 to 7.3 per cent in 2018. Realised returns were good in 2017, reaching 7.1 per cent, just 0.3 per cent away from the target. However, last year, that gap widened considerably to 4.9 per cent, with realised returns reaching just 2.3 per cent.
With hedge funds, investors have a certain expectation that they can use them to hedge part of their book to dampen volatility. One of the levers they can pull is to increase the concentration of managers in their portfolio and hopefully bump up returns.
According to Barclays Capital, investors experienced ‘Di-worse-ification’ as they increased the number of managers in 2018.
Those investors with 11 to 20 managers had the highest returns on average (3.3 per cent), while the most diverse investors – those with more than 30 managers – had the lowest returns (0.1 per cent).
Investors are looking more meaningful relationships with a fewer number of managers and this study would suggest they are wise to do so.
Ten years, it was acceptable for investors to have 100-plus manager relationships but that is no longer the case.
“They’ve been decreasing their relationships over the years and what’s happened is no matter how good you are at manager selection, if you have more than 30 managers in your portfolio the closer you get to resembling the index. What is now happening is investors want to concentrate and really let their manager selection shine. Those who have between 10 and 20 managers in their portfolios…that seems to be the number that has allowed them to differentiate from the underlying index and demonstrate their edge in manager selection,” suggests Altshuller.
Another lever that investors can pull to improve their overall hedge fund performance relates to liquidity. As is well known, people get paid for taking on illiquidity risk – and in the Barclays Capital study, it is unsurprising that less liquid portfolios outperformed more liquid portfolios. Private/illiquid credit is the most highly favoured non-traditional strategy in 2019, with investors in particular citing small managers, with less than USD500 million in AUM, as those they are most interested in.
Altshuller also suggests that fees play a factor in performance. Investors paying the above median management and performance fees achieved the highest net-of-fee returns in 2018.
This observation also held true for 2017. This finding suggests that investors should focus on finding the best managers, rather than the lowest-cost managers.
“The lower the fees you pay, the more likely you’re going to get what you pay for. We found that the highest net returns after fees were actually from the HF portfolios paying the highest fees,” concludes Altshuller.
