The institutional interest in hedge funds has continued to increase as expectations for equity and fixed income returns have been falling. Recent anaemic hedge fund returns have raised questions about future performance. However, risk-adjusted returns have been holding up while risk targets have been reduced.

The days of relying on double-digit annual returns from equity markets appear to be over. Valuations are high and money will not be cheaper in the future. The bond market does not provide much comfort either, with yields being close to historical lows and central banks having provided ample liquidity for quite some time. Commodities have already staged an impressive rally, currency managers are struggling in a trendless market and real estate seems to be close to a bubble. Many agree that generating returns in the future will be less easy and that increasingly we will have to depend on finding elusive ‘alpha’ - the outperformance of market indices. We still believe that hedge funds are the best place to find alpha and that clients should allocate more risk to this area. Hedge fund guidelines and incentive structures promote the generation of outperformance and, as a result, a large part of the investment talent has migrated into this sector. Hedge funds simply mean better managers with better opportunities.

Risk-adjusted returns holding up
But how do we explain that hedge fund returns have been trending lower since the late ‘90s and that many managers show negative performance year to date? The last two quarters have been tough given the unfriendly environment for many of the hedge fund strategies. However, no investment area will be successful all the time. Several hedge fund strategies have been pronounced dead only to re-emerge later. The articles hailing the death of global macro and systematic trading in the late ‘90s are a good example.
When it comes to the long-term trend, we have to be clear about what type of returns we are talking about. Even though the level of return has fallen somewhat since the late ‘90s, the risk-adjusted return - return in excess of the risk free rate per unit of risk or ‘Sharpe ratio’ - has been holding up rather well. Looking across all hedge fund strategies, risk-adjusted returns on a rolling 24-month basis are back to historical averages. (see graph). What this tells us is that returns mainly have come down because the risk free rate is lower and managers and clients take less risk.

Falling risk appetite
Why has the risk appetite fallen? Given the nature of risk-adjusted returns it is important to consider the return as well as the risk side of the equation. First, clients will conduct comparisons with other asset classes when forming their return expectations for hedge funds. At the end of the ‘90s equities were generating double-digit returns. However, during the ensuing equity bear market, the rallying bond market became the new benchmark and now when bonds have become less attractive, the relevant comparison seems to be cash returns. As a result, hedge funds can target lower risk levels and still deliver competitive returns. Previously many funds targeted risk levels close to those of equity indices, i.e. annualised volatility above 15%. Now bond-like volatility at roughly a third of that level appears to be the norm and, with bonds looking less attractive, risk targets could fall further. The only factor on the other side of the ledger is that many investors expect higher returns from their hedge fund allocation, simply because it has become one of the few generators of performance.
Secondly, lower traditional asset returns seem to have increased clients’ sensitivity to risk in their hedge fund allocation. With no performance cushion elsewhere, hedge funds are expected to generate returns without major drawdowns, which has led to lower risk targets. Thirdly, there is now more institutional demand for single hedge funds targeting significantly lower risk levels than most high net worth individuals and fund of funds are usually looking for. Finally, with management fees seldom being adjusted for risk levels and capacity often being a scarce resource, the incentive for managers to provide a concentrated investment is minimal, especially if the diluted one sells better at almost the same price.

Unrealistic Sharpe ratio expectations
It is always difficult to meet the demand of generating attractive returns while taking very little risk.
The answer is usually a promise of a fantastic Sharpe ratio. Here, many participants in the hedge fund industry have to share the responsibility for supporting unrealistic expectations. A long-term sustainable Sharpe ratio of one, i.e. to be able to generate 1% return over the risk free rate for every 1% of risk, must be considered attractive for a single hedge fund. A good fund of funds should be able to generate a higher ratio than single hedge funds while diversifying business risk. Even if you are in the best place to receive the alpha you are looking for, you have to target a reasonable amount of risk instead of relying on an excessively high Sharpe ratio.

Future opportunity sets
What about the future? Can we expect hedge funds to continue to deliver good risk adjusted returns while traditional index returns are disappointing? Is it really advisable to allocate more risk to the area? We believe that hedge funds will continue to outperform and would advocate a significant allocation to the area. However, with reduced prospects to bolster hedge fund returns with market-related index returns or beta, we expect that there will be an increased focus on exploiting the opportunities to generate alpha. This could accelerate the cycle of managers flocking to rich opportunity sets, these sets becoming depleted, mangers leaving the space and the opportunity sets either recovering or a new set being created. It could also lead to temporary convergence between different hedge fund strategies, as managers migrate more rapidly to the most promising areas regardless of their strategy label.

Specialist skills more
We therefore think it will become increasingly important for anyone investing in hedge funds to be able to go beyond the strategy labels and to follow and interpret actual portfolio information in order to understand the positions and the risk factors to which hedge fund managers are exposed. Without that expertise, it becomes increasingly difficult to assess the relevant skill sets and to construct well-balanced portfolios. For example, behind the convertible bond arbitrage label could be a credit risk manager and your overall portfolio could already have a high exposure to credit risk from many other strategies.
We also believe that the focus on portfolio construction and the capacity to form views about opportunity sets will increase. In order to generate returns and avoid problems, fund of funds managers have to be able to forecast which areas run the risk of becoming overcrowded and where hedge funds might be taking excessive risks to eke out returns. High leverage relative to returns and mismatches between the duration of the hedge funds manager’s assets and liabilities are usually tell-tale signs. Another area of increasing importance is the relationship between different strategies and opportunity sets in different market scenarios and what the impact on the portfolio might be. If, for example, higher short-term interest rates combined with a flatter yield curve led to deleveraging as carry trades became less attractive, previous diversification benefits within high yielding assets would disappear with many of those assets selling off at the same time.
The bottom line is that we are likely to have to rely increasingly on alpha to meet return objectives and that hedge funds are still the best place to generate good Sharpe ratios. As the competition for alpha increases, the fund of hedge funds area becomes more complex and the need for specialist skills and deep understanding becomes more vital. With fewer free lunches it might be time to take a closer look at the quality of some of the restaurants.