There is a disconnect between perception and reality when it comes to hedge funds which could lead to poor decisions by institutional investors.
Newspaper headlines give the impression that hedge funds are facing extinction. It was recently reported that exchange-traded funds have surpassed hedge funds in terms of total assets under management. There have been reports of high-profile institutional investors shunning hedge funds.
The truth is hedge fund assets are growing, albeit at a slower pace. Returns have been under pressure but this has to be seen in the context of a multi-year bull run in equities and bonds (and a tough time for commodities). Many hedge funds are equipped to provide higher rewards during times of high volatility as they have the skills and processes to profit from it.
Several factors account for the reticence about hedge funds. First, fees are often still too high despite lower returns. This should be addressed, but can also be true in active management.
Secondly, the hedge fund industry is undergoing structural change. Hedge funds are launching liquid versions of their strategies. Traditional managers are launching hedge fund-like strategies. Academic studies have shown that the performance of many hedge funds is derived from systematic exposure to certain risk premia. In short, the boundaries between hedge funds and the rest of the asset management industry are no longer defined.
Finally, many jurisdictions still limit access to alternative managers. However, regulatory initiatives have eased access to the hedge fund world.
Investors should not be deterred. A well-structured alternatives allocation can be highly leveraged, particularly in periods of high market volatility. It is true that pension funds can choose from assets including private equity, private debt and infrastructure. But these present a different proposition from hedge funds, which can offer better liquidity and risk-adjusted returns. Furthermore, the real assets and private debt markets are getting crowded.
Pension funds should not take the a priori view that hedge funds do not deliver. Capable investors should do their homework and learn how to select successful managers in the same way they select real assets and private debt opportunities.