Are Institutional Investors Done With Hedge Funds?

bandaidDespite the withdrawal by institutional investors of more than $100 billion of capital from the hedge fund industry in 2016, some Canadian pension funds are still confident in the asset class.

“It makes me question why those pension funds or institutional investors invested in hedge funds in the first place,” says James Davis, chief investment officer at OPSEU Pension Trust. “When we invested, we had a specific objective, which is uncorrelated returns to complement the portfolio that we currently had with more traditional assets.”

Investors were likely disappointed with hedge funds if they expected better rates of returns than equities or they had reallocated funds from other assets to them, says Davis. “I think, in some cases, that’s part of the reason. When I bought this asset, I sold something to buy it. When they sold equities, they’re perhaps disappointed that they didn’t get a rate of return that they would have gotten from equities.”

The comments follow a recent report by Prequin, a data and intelligence company based in London, England, that showed outflows from hedge funds totalled $110 billion in 2016.

Hedge funds produced low returns in 2014 and 2015, which contributed significantly to the outflows in 2016, says Amy Bensted, head of hedge fund products at Preqin, a data and intelligence company based in London, England.

According to Preqin’s global research, the overall rate of return for 2015 was 1.13 per cent for hedge funds of all strategies and regions, a drop from 3.48 per cent in 2014. In 2016, the overall return recovered to 7.4 per cent, but by then the industry has already seen many institutional investors withdraw capital, says Bensted.

“This year will be a really important year for the industry,” she says, noting it’s clear the industry is more aware of investors’ concerns about performance and fees.

Preqin’s 2016 survey showed 47 per cent of hedge fund managers felt they had experienced a more challenging environment that year in comparison to 2015. About a quarter (26 per cent) said they found it harder to retain assets due to investors continually evaluating their hedge fund allocations.

The exodus of giant pension funds, such as the California Public Employees’ Retirement System in 2014, had a significant effect on the hedge fund industry, says Bensted.

CalPERS withdrew about $4 billion from the industry because it found the funds’ performance didn’t warrant the costs, noted Ted Eliopoulos, chief investment officer of the pension plan, in a press release at the time.

The pension fund’s decision had a ripple effect, notes Bensted. “What we saw in the course of 2015 and 2016 is more pension funds making similar decisions to leave the asset class as a whole or reduce exposure to hedge funds.”

But while several large pension funds have withdrawn from the industry, there are just as many that are sticking with hedge funds, says James Burron, chief operating officer at the Alternative Investment Management Association in Canada. “I haven’t really seen the pedal come off the gas. Typically, headlines are someone comes out and it’s a big headline, but you don’t see the other five or six that are getting in,” he says.

Pension funds probably withdrew if they expected hedge funds to outperform other asset classes, says Davis. “When we look at hedge funds, we always benchmark returns of a cash, plus risk, premium.”

The pension fund’s goal is to get uncorrelated returns and diversification in its overall portfolio, says Davis. And in that respect, he finds hedge funds’ performance has been consistent.

“Over the past three years, when we look at [our hedge fund] program in totality, it’s performing consistently with what we expected,” says Davis. “The sharp ratios are attractive and the returns are consistent with the risk premiums we would have expected. Maybe earlier, in mid-2016, returns were not looking so great. There’s been a recovery since then. But I would never expect positive rates of return all the time, not with any asset class. So in the longer term, we’re getting results consistent with what we expected.”

In order to draw back investors that have left the asset class, hedge fund managers are willing to become more flexible with fees, according to a Preqin survey published in November 2016.

Pension funds are now actively evaluating the value of their hedge funds, says Burron. He notes many investors are now pulling apart the returns of hedge funds to assess the fees and approaching their hedge fund managers to discuss the fee schedules.

The industry is maturing and becoming more competitive, says Davis. “From our own perspective, when we do surveys and due diligence on managers, we always look at how those managers are compensated and make sure they’re absolutely aligned with the investment objectives that we have for that particular manager.”