Pension funds and endowments have been the backbone of the hedge fund industry for much of the past decade. But many of these institutional investors are now turning away from the $3tn-in-assets sector, dismayed by high fees and relatively lacklustre returns.Sanjiv Bhatia is absolutely right, people chase performance and pension funds aren't any different, they love chasing performance.
“We got out of most of the hedge fund portfolio,” said Scott Wilson, chief investment officer of the $8.9bn endowment fund at the Washington University in St Louis, Missouri. “We don’t want any investment just for the sake of having that investment.”
Since Mr Wilson’s appointment two years ago the fund has slashed its allocation to hedge funds from about 20 per cent of the portfolio to little over 10 per cent. He plans to rebuild that share to about 15 to 20 per cent over time, but will do so cautiously. “It’s not that all hedge funds are bad, but you have to be very careful in the selection process,” he said.
The reshuffle comes after years of largely uninspiring performance from the hedge fund sector. Managers have underperformed the S&P 500 stock index every year since 2009, both in rising and falling markets. Last year provided hedge funds with their best returns in a decade, but they were still well behind the market.
The current bull run in stocks — the longest in history — has increased the appeal of tracker funds, which charge much less than hedge funds. Interest in private equity and debt has also boomed as investors have looked beyond expensive public markets for opportunities.
Mike Powell, head of the private markets group at London-based USS Investment Management, which manages the £68bn Universities Superannuation Scheme, said it had reduced its hedge-fund holdings to less than 2 per cent of assets, from 4 per cent five years ago.
The pension fund is also planning to further reduce the number of hedge fund positions “to focus only on those that offer strategic alignment with our investment priorities and clear value-for-money”, said Mr Powell. The key problem with respect to hedge funds has been “the continued disappointing performance . . . at a time when fees have remained high”, he said.
UK local authority pension funds, including West Yorkshire Pension Fund and Hampshire Pension Fund, are also turning away from the sector. Hampshire is selling out of a hedge fund portfolio with Morgan Stanley, in favour of a private debt mandate with JPMorgan.
“The current low volatility environment has made it difficult for hedge funds to perform and, as a result, [investors] are asking questions on how they allocate in a way that they previously did not,” said Dan Nolan, a director at Duff & Phelps, a professional services group.
Tracking institutional investors’ appetite for hedge funds is tricky. Investors in aggregate pulled $43bn from hedge funds last year, their second-highest withdrawal since 2009, after $38bn of withdrawals in 2018, according to data group HFR.
Since 2015, the share of total hedge fund assets coming from public and private sector pension funds, endowments, foundations and insurance companies has slipped from 71 per cent to 67 per cent, according to data from the Alternative Investment Management Association, a London-based body.
Any sign that institutional investors are moving out en masse would be a blow for a hedge fund sector that has grown dependent on their cash, after many wealthy investors and private banks pulled back during the credit crisis.
“It is true there has been a waning of interest over the past two years,” said Jack Inglis, AIMA’s chief executive. “However, recent investor surveys suggest that sentiment for 2020 has turned positive and institutional investors are stating an intention to increase their allocations once again.”
The data are not conclusive. A Deutsche Bank survey early last year of investors with $1.7tn in hedge fund assets found that 42 per cent of pension funds had increased their exposure, while just 14 per cent reduced it.
However, an EY study, based on 62 interviews with investors managing $1.8tn in assets, found that institutional investors’ allocation to hedge funds had dropped to 33 per cent of their alternative investments last year from 40 per cent in 2018.
Some big-name institutions had already pared back their allocations. In 2014, US public pension fund Calpers said it would stop investing in hedge funds, while the following year Dutch pension fund PFZW said it had “all but eradicated” its hedge fund positions.
Others are considering similarly radical measures, after two years of losses in the past five. “There’s a very strong recency bias in all investment decisions,” said Sanjiv Bhatia, who runs the Pembroke Emerging Markets hedge fund in London and previously managed emerging-markets portfolios for Harvard’s endowment.
“People chase returns, and it’s no different at the top of pension funds,” he said. “People up there are not more visionary.”
Back in 2012, I wrote a very critical comment on the rise and fall of hedge fund titans, noting the following:
I've never met John Paulson. I have met other hedge fund titans like Ray Dalio and discussed deflation and deleveraging with him long before Bridgewater jumped on that bandwagon.Back in 2003, Vega Asset Management, a global macro fund based in Madrid, saw its assets explode from $1 billion to over $12 billion in a couple of years.
But even though I've never met Paulson, I can tell you that I always thought his fame and status was grossly inflated by the media, allowing him to gather billions in assets. Now that he's struggling, his publicized woes will work against him.
Look, Paulson wasn't alone to profit big time off the 2008 financial crisis. One of my favorite hedge fund managers, Andrew Lahde, returned 866% betting on the subprime collapse and then had the foresight to walk away and say goodbye.
Paulson decided to stick around. His life, his prerogative, I don't fault any man who wants to continue earning a living doing what he loves best.
But I will tell you Paulson's rise and fall is nothing new. I've seen it many times before. Typically, hedge funds have a great track record, or an incredible year, consultants and brokers start spreading the word to institutional investors and in no time assets under management explode up.
That's when your antennas should go up and you need to start thinking of pulling out. Whenever I see assets explode up, from $5 billion to $40 billion, I pay very close attention because it usually spells trouble ahead.
That's exactly what happened with Paulson. He was riding the coattails of his outsized returns, assets under management mushroomed and returns subsequently faltered. Seen this so many times and yet the institutional herd keeps piling onto yesterday's winners like moths to a flames.
It's all part of human nature. Nobody wants to hold losers in their portfolio. Only winners. But in the game of hedge fund investing, the easiest thing is to write a big fat cheque to some well known hedge fund. Much harder to know when to pull the plug and when to allocate more to a struggling manager.
I remember meeting Ravi and Jesus, the two managers, and was impressed with their trading and risk management, but something irked me about their views on long bonds (they were short, I was long) and the 'Vega marketing machine' so I recommended we allocate a small position into this fund.
All went well for a couple of years and then the fund got clobbered and never recovered. I'm giving you the short version but I can tell you allocating to hedge funds isn't an easy game, especially directional hedge funds which I was in charge of back then.
"Leo, we have very limited capacity, you need to make a quick decision." If I had a dollar every time some hedge fund manager sang me that song, I'd be rich.
In the hedge fund world, there are very few true alpha generators which consistently deliver high risk-adjusted returns.
In a recent comment covering the best and worst hedge funds of 2019, I discussed why Ken Griffin's Citadel deserves the top spot and stated this:
[...] my best advice for 2020 is stick with Griffin and Cohen but also increase exposure to Izzy Englander’s Millennium and Dmitry Balyasny’s Balyasny Asset Management as they tend to outperform in tougher markets (on a risk-adjusted basis and not always the case).There are other top quant funds and some like Renaissance Technologies is puzzling to one finance professor who believe the famed Medallion Fund "stretches explanation to the limit".
You need to be careful out there and realize there's a lot of hedge fund smoke being blown and in a world where beta rules the day, typically hedge funds with a lot of beta embedded in their strategies are the ones that garner all the media attention.
I'm serious, be careful when you read articles about how some hedge fund star posted blowout gains last year. So what? One year doesn't make you a hedge fund star!!
There are a few things that have fundamentally and irrevocably altered the hedge fund landscape since the 2008 crisis:
- Too much money investors chasing alpha leads to a lot of crowded trades among top funds. All the top hedge funds are all playing in the same trading field and all are managing their liquidity risk very closely.
- Long bond yields have plunged and along with them, returns are coming down.
- The Fed and other central banks have flushed the financial system with excess money and keep doing so, effectively making beta great again. This has led to the rise in passive investing and has made in exceedingly difficult for hedge funds which used to profit off of major dislocations (lack of trends in major markets).
- Investors are tired of paying excessive fees to hedge funds especially if they're underperforming in up and down markets.In a low-rate, low-return world, it becomes much harder justifying 2 & 20 or even 1 & 15.
- Investors prefer illiquid alternatives like real estate, private equity, infrastructure and private debt over liquid alternatives (hedge funds) because they can scale into them and get better alignment of interests over the long run.
Not surprisingly, given the lousy performance last year, hedge fund fees plummeted in 2019. However, there are new smaller hedge funds outperforming and not charging any management fee, but it remains to be seen what staying power they garner in the ultra competitive hedge fund world.
As far as big investors bowing out of hedge funds, I don't buy it. Now isn't the time to bow out, now is the time to carefully add to true alpha generators and build long-term relationships which you can leverage off of.
The problem remains finding hedge funds which can consistently deliver alpha.
John Kenneth Galbraith once famously quipped: "In a bull market, everyone is a financial genius."
Well, we've had a 11-year bull market backed by the Fed and global central banks since March 2009 and a lot of long-only active managers don't look like financial geniuses, they look like financial novices which consistently underperform their benchmark.
The same goes for hedge funds touting "absolute returns in al market environments", most are falling short of what they're suppose to deliver which is why some very high profile funds end up closing shop and being converted to a family office (the lucky few which rode the fee gravy train over the last three decades).
So, when I look back at CalPERS nuking its hedge fund program back in 2014, I can't say they made a mistake, but I can't help thinking, if they took that program seriously (like CPPIB and OTPP), they would have made a lot of money over the last five years and added substantial alpha.
Below, a little over a month ago, hedge fund legend Stanley Druckenmiller discussed stock market volatility and the performance of the hedge fund industry with Bloomberg's Erik Schatzker. Druckenmiller told Schatzker he's 'not surprised' that hedge funds are suffering.
Next, Mithra Warrier, managing director of US head of prime brokerage sales at TD Securities, joins BNN Bloomberg to discuss why hedge funds are struggling to stay afloat.
Lastly, the Fed held interest rates steady at its meeting this week and tweaked its post-meeting statement to reflect what appears to be a stronger commitment to nudge up inflation. “We wanted to underscore our commitment to 2% not being a ceiling, to inflation running symmetrically around 2%and we’re not satisfied with inflation running below 2%,” Fed Chairman Jerome Powell said during his post-meeting news conference.