Faith remains, but less absolute

Ben Power

By

26/09/2016

When Conexus held its first Absolute Returns Conference 10 years ago, Australia’s hedge fund industry was in relative infancy. There was still a whiff of cowboy about the local hedge fund managers who took their cue from swashbuckling US managers. High net worth and endowment investors were less demanding, and fund of funds were influential.

But then the global financial crisis hit.

Many investors turned their back on hedge funds. Others persisted, but they began increasing pressure on the hedge fund industry to become more institutionalised and provide greater transparency, operational robustness, and increasingly lower fees.

But despite those changes, many investors believe the industry still has further to go if it is to become fully institutionalised.

“There’s still a way to go for the hedge fund industry to be fully institutionalised,” says Bruce Tomlinson, portfolio manager at Sunsuper, which has $2 billion allocated to hedge funds. “There are a lot of practices that aren’t perfectly aligned with institutional requirements. The whole industry has been happy to accept institutional capital but it hasn’t evolved enough to become better aligned with those institutional requirements.”

But now lacklustre performance and a low-return environment has put renewed pressure on hedge funds to continue to evolve to meet the needs of investors, who are pushing for further cuts to fees, greater tailoring and co-investment, and delivery of truly portfolio-enhancing strategies. That push could provide the final impetus for the industry to complete its institutionalisation.

 

Twice as many hedge funds

According to the Australian Security and Investment Commission’s (ASIC) Snapshot of the Australian Hedge Fund Sector, back in 2006 there were just 234 hedge funds in the country. (Of those, 40 were funds of hedge funds.)

The number of funds doubled to 473 in the period to September 30, 2014, and included 398 single-manager funds and 75 funds of hedge funds with a total of $95.9 billion of assets under management.

Despite the growth, most hedge funds remain relatively small with assets under $50 million. But the past decade has witnessed a surge in the size and power of major institutional investors. At March 31, 2016, the Future Fund alone had $14.9 billion, or 12.7 per cent of its portfolio, in alternatives.

Hedge funds have been forced to institutionalise as they sought to attract capital from big investors. “The industry has definitely become far more institutionalised in the past 10 to 15 years,” says Robert Graham-Smith, senior investment analyst at industry fund Mine Wealth + Wellbeing, who has been analysing hedge funds since the early 2000s. “With that comes asset growth and a change in behaviour of managers.”

There has been a much greater focus on transparency and operational risk, such as a spotlight on an underlying manager’s exposure to counterparties.

Tomlinson agrees that post-GFC, in aggregate, managers have improved their business management, including their middle back-office operational capabilities. “We do see improvements in those operating capabilities and better business capabilities,” he says. “It’s not just investment teams, but investor relations and operations capabilities within those managers has improved post-GFC.”

As institutional investors have grown, they have also become more sophisticated and have increasingly shifted their investment programs from fund-of-funds to direct investments.

 

Fund of funds suffered unexpected losses

Michael Sommers, head of alternatives at Frontier Advisors, says fund of funds suffered after the GFC. “Investors had been in fund of funds that were supposed to be pretty diversified but suffered unexpected losses as well,” he says. “Those strategies were there to provide diversification in such an event relative to equities. It’s quite likely fund of fund investors, and indeed the fund managers as well, weren’t fully appreciative of how undiversified the actual portfolio was.”

Sunsuper began its alternatives program in 2007 with a hybrid investment mix of direct and fund of funds. But it went fully direct after the GFC in 2009. “It’s about control,” Tomlinson says. “You can negotiate things like improved terms, transparency, and co-investments. All those things come with being direct.” The fund has evolved its strategy to be “much more than liquid evergreen hedge funds”. It now includes closed-ended longer-duration strategies, as well as liquid short-term duration strategies.

Institutionalisation and the impact of the GFC also saw managers adapt strategies. Graham-Smith says that overall the hedge fund industry has become a bit more consensus-driven. And larger managers are focussed on steady, incremental performance with no surprises. “They are playing to their audience of institutional investors,” he says. “There’s much less focus on so-called key person funds, which historically have had a higher volatility and return expectations.”

But while hedge funds were getting their house in order post-GFC, a new set of challenges has emerged. Central bank intervention cut volatility and spawned a low-return environment. “It remains a challenge for investors globally: the generation of decent risk-adjusted returns has been more difficult with the backdrop of low interest rates in the past few years,” Graham-Smith says.

The low-return environment means investors are struggling to deliver on return expectations, and made it challenging for hedge funds to deliver excess returns.

Recent performance has been particularly lacklustre. According to a Barclay’s report, Against All Odds, released in August, hedge funds globally produced considerable excess returns since 1993, but that has plateaued since 2011. The report, which surveyed 340 investors around the world, found that more than half of those investors indicated that hedge funds didn’t meet their expectations over the past couple of years.

 

Seeking fee discounts

Barclays found the major response from investors around the world in the wake of poor performance has been to seek out fee discounts. That is being reflected in Australia, with many big investors believing managers need to cut fees.

“There is growing pressure on fees in the industry, especially in a lower-return environment,” Graham-Smith says, adding there is growing pressure to change the structure of those performance fees, particularly in terms of claw backs or loss recovery mechanisms.

“Some managers are definitely coming to the party, and there is a willingness to work with investors, particularly larger institutional investors, on that basis,” he says.

Tomlinson says fees generally are too high. “The alignment isn’t appropriate,” he says. “I think there’s still too many managers with inappropriate fee structures.” That includes performance fees over zero, “particularly when there is some sort of factor or beta or spread involved.”

Tomlinson believes that performance fees should be more backended, and instead of being charged every year, they should be paid over a longer time period. That, he says, would improve alignment, and investors wouldn’t face high fees one year, followed by underperformance for a couple of years. “If fees were paid over three years, [in the event of later underperformance] the investor wouldn’t pay the fee or pay a lot later,” he says.

The industry also needs a conversation about the fees embedded within a strategy, Tomlinson says, including administration fees and transaction costs such as brokerage and costs involved with leverage. “Those fees are quite material,” he says. “They can add another 100 to 200 basis points of costs depending on the strategy. But we don’t see any pressure to bring those down. Sure, it comes out of net returns, but it’s a cost nonetheless.”

The Barclays report found that beyond fee negotiations, investors are using manager selection to adjust their hedge fund allocation. There is particularly a shift away from ‘run of the mill’ managers with undifferentiated returns and multiple sub-scale products.

Frontier’s Sommers says investors are seeking strategies that offer some stable return potential, produce outperformance when markets are volatile and/or falling, but also have relatively low fees.

Those include “liquid diversified strategies” (also sometimes referred to as “relative value multi-asset” strategies) that take a macro view, consider trade ideas that express this view, add in some short positions to reduce common market beta (e.g. long Germany equities vs short French equities) and then add in some protection to reduce the possible size of the loss for the trade idea should they get it wrong. In doing this, the fund manager can build up a stable return profile in “little bits and pieces as they diversify the portfolio across a number of little trades to spread the return drivers”. Sommers dubs them “macro lite.”

“They’re not expensive and not super active,” he says. “They’re a lot easier to understand for the client.” He adds: “Complexity is a now a big thing. Trustees need to understand what’s in their portfolio. Very complex strategies will struggle to get in with most clients.”

Sommers says that CTAs, such as trend followers, may generate interest because they have pretty good risk-adjusted returns, are quite diversified, offer the potential for strong returns in market falls, and are lowering fees to Australian investors.

Alternative beta is also becoming popular, with a focus on more advanced approaches to portfolio construction and is viewed as a lower-cost approach to accessing diversified returns. Insurance-linked securities may also see interest; these offer attractive risk-adjusted returns and very low correlation to other asset classes such as equities and credit.

 

Opportunistic investments

Despite the quest for reduced complexity and fees, Sommers says investors are also interested in opportunistic investments such as stressed and distressed debt, which offer returns of 10-15 per cent and, in some instances, reasonable fees. Some fund managers are taking advantage of the withdrawal of banks from credit markets and are stepping in to provide loans to mid-market companies in the US.

Another characteristic that is increasingly attracting investors is the ability to partner with funds. The past decade has seen investors become closer to managers.

“We try and get very close,” Tomlinson says, adding that Sunsuper might meet with a manager on-site two, three or even four times a year.

But those meetings now often turn to their core positions and, according to Tomlinson, the prospect of co-investment, particularly in credit: if it’s such a high-level conviction position in your fund, how can we get exposure to it in a more fee-friendly way?

Investors are seeking a “more flexible structure so you can more flexibly add capital when opportunities are there, in more of a partnership approach with managers, rather than investing passively in an evergreen fund,” Tomlinson adds.

Not every manager is open to that. “There are still quite a few managers who say ‘this is our fund; it’s 1.5 and 20; that’s the only way you can invest in us, take it or leave it’,” Tomlinson says, adding that only around a third of funds are willing to be flexible.

Despite the challenging conditions, the good news is that in a broad sense investors remain committed to hedge funds. The Barclays survey found that only a minority of investors were planning to cut back on hedge funds investment. It says that investors were still by and large faithful to hedge funds, even if they are disappointed by recent performance. “One of the most important reasons is that it is difficult to find an alternative with similar risk/return characteristics.”

Barclays expects, at a baseline level, for global assets under management to remain flat at $US2.9 trillion, with low-positive returns offsetting a net $US30 billion of redemption.

 

Continued pressure on hedge funds

Hedge funds and absolute return strategies have contributed, and continue to contribute, to portfolios. Tomlinson says for Sunsuper they have achieved their net target of cash plus 5 per cent over the medium to long term. The fund has trimmed its allocation of hedge funds from 7 per cent of its portfolio to 6 per cent as part of a general reduction in alternatives, given issues such as fees and liquidity, but there are no plans to change that in the short term.

But hedge funds will continue to face pressure, and investors’ faith could waver.

According to ASIC, the number of new hedge funds launched each year was strong between 2005 and 2011, at around 30 per year. But that has begun to tail off. In 2014 just four single-manager funds were launched, and no funds of hedge funds.

Barclays expects the number of funds globally to shrink in 2016, with fewer launches and a rise in liquidations. “There is definitely a recognition that hedge funds, along with other absolute investment strategies, have to justify their place at the table in terms of performance expectations,” Graham-Smith says.

“There’s a challenge across the whole hedge fund industry to start generating stronger performance to justify the fees that investors are paying,” he adds. “I don’t think that’s an unfair observation. Unless that’s forthcoming, I expect there will be some potentially significant turnover of managers and assets within the industry that could provide challenges in itself. You’re paying high fees for what you expect to be smart investors. Unless they can justify those fees, there are big challenges ahead.”