Negative sentiment against hedge funds is overblown providing investors can identify the right managers using a robust approach, according to Chris Redmond

The role, viability and prospective future success of hedge funds in institutional client portfolios is a hotly debated topic. Indeed, there are two main schools of thought in direct opposition to one other. But which camp is correct? Context is key, perhaps unsurprisingly. 

Perversely, we agree with both the positive and negative perceptions about hedge funds. But rather than implying that we lack of clear view or that there is a clear winner in this debate, we simply apply the arguments to drive our investment beliefs and to focus our research to screen the hedge fund universe. By addressing these pros and cons and by incorporating the asset owner’s perspective, we can identify the hedge funds that can play a role in portfolios, which is why we find ourselves continuing to allocate capital to them.

In abstract, hedge funds represent the most efficient means of accessing manager skill. Unshackled by restrictive investment guidelines or the more onerous capital charges imposed on regulated entities such as banks and insurance companies, hedge funds are free to generate returns in an unconstrained manner. Notably, they benefit from the ability to access the broadest possible opportunity set to precisely reflect investment views – investing both long and short, across the entire capital structure, applying leverage to amplify returns from arbitrage trades and so on – which serves to assist efficient alpha creation.  

The other main attraction of hedge funds to institutional investors is the potentially powerful diversification benefits and downside protection they can provide at a holistic portfolio level. Hedge funds can play a particularly valuable role in portfolios in periods of equity or credit market volatility, such as the summer of 2015.

The issue of fees is increasingly acknowledged and the main concern is a hedge fund industry synonymous with ‘2-and-20’ fees (a 2% management fee and a 20% performance fee). These fees are unjustified in the case of most, although not all, managers.  

Another key issue associated with investing in hedge funds is governance. Insufficient governance can result in disappointing returns from a hedge fund portfolio comprising average managers or, worse, create headlines and reputational issues from investment in managers that suffer a severe loss. 

Attempting to support a hedge fund portfolio in a world of finite governance can prove a significant distraction from more critical decisions around strategic asset allocation. Furthermore, stakeholders and beneficiaries may not have the investment expertise to properly judge whether managers are delivering returns that are diversifying and worth the hefty fees. Pressure on fiduciaries and the time and effort required to justify the level of fees increases the governance cost even more.  

For some investors the negative arguments have won out, no doubt also taking into account lacklustre recent returns from hedge funds. Furthermore, certain high profile and large institutional investors have chosen to exit their hedge fund programmes, which has attracted significant attention and added to the general negative sentiment. However, these same institutions have said that returns were not the reason for their decision; rather, the diseconomies of scale associated with deploying huge amounts of capital into many hedge funds has proven a limiting factor in a capacity-constrained market segment.  

Percentage of hedge fund strategy and industry returns explained by combinations of bulk beta and alternative beta

So are the pros or the cons correct? In our view, for investors with the appropriate beliefs and governance, hedge funds can play a powerful role in portfolios.   

The key to success requires investors to stop classifying hedge funds as an asset class. Instead, success follows from a better understanding of what hedge funds can deliver and focusing on those funds that can provide the value-added elements. This requires a deconstruction of returns into the component drivers or risk premia, which are:

• Cash: the risk-free returns embedded in the securities managers hold.

• Bulk beta: traditional return drivers such as equity or credit. It is not necessarily bad that hedge funds dynamically capture these accessible and inexpensive forms of beta; the key is to avoid paying hedge fund fees for more structural exposure.

• Alternative beta: these are diversifying return drivers that can be beneficial to portfolios – for example, carry, reinsurance, merger arbitrage, and so on. Traditionally, hedge fund managers would deliver these returns and charge for it as if it were alpha. But as the institutional investor community has become more sophisticated investors see that this can be accessed elsewhere and for less.

• Alpha: this last return driver is essentially the portion of return that cannot be explained by the above. It is what we would define as skill-driven and is worthy of hedge fund fees.

Disappointingly, a surprising proportion of hedge fund industry returns can be explained as a combination of bulk beta and alternative beta, as illustrated in the figure. Put differently, in the case of the average hedge fund, investors are likely to be paying very high fees for embedded beta that could more easily and cheaply accessed elsewhere.

However, this need not be the case for a discerning buyer whose goal is to access manager skill (or alpha) efficiently and achieve returns with a low correlation to other commonly held assets. Specifically, hedge funds offering low net exposure are most appealing in the context of building robust portfolios and achieving good value for money – for the return profile they offer, rather than because of the hedge fund label. Returns would not be attributable to bulk and alternative betas in the case of a portfolio consisting of this type of manager.

Investors understand the need to build diversified portfolios, given today’s interest rates and credit spreads and considering the recent volatility of equities. A framework of return deconstruction facilitates portfolios that are optimally diversified across different return drivers and highlights the important role hedge funds can play.

Growth in the hedge fund industry is expected to continue, with institutional investors most likely continuing to drive much of this growth. The primary motivating factors are the benefits they see related to diversification and enhanced risk-adjusted returns.  

Negative sentiment towards active management and hedge funds, fuelled by mediocre performance and high fees, is challenging the longer-term story. This negative sentiment is overblown, particularly for a discerning buyer. It is the wrong time to capitulate.  

Instead, it is more important than ever for investors to prioritise robust manager due diligence and to identify solutions that improve portfolios with fees that truly reflect the talent of the manager. The benefits of incorporating hedge fund strategies can be compelling when the right managers are identified and the fees are aligned.

Chris Redmond is global head of credit at Towers Watson