Institutions are delivering a double whammy to hedge funds this year by reducing the level of new investment and increasing redemptions.
New assets invested in hedge funds and hedge funds of funds by asset owners totaled $8.5 billion in 2018, down 13.7% compared with 2017 and down 22.8% from five years' earlier, showed Pensions & Investments' analysis of hedge fund activity reported in the newspaper as of Dec. 15.
Net inflows to hedge funds and hedge funds of funds in 2018 were the lowest in the five-year period.
In contrast to new investments in hedge funds and funds of funds, terminations were elevated compared with prior years, but were much smaller in terms of aggregate dollars.
Redemptions from hedge funds rose 15.3% to $1.33 billion year-to-date through Dec. 15 compared with all of 2017 and were up 13.3% compared with five years earlier, while terminations of hedge funds of funds totaled $889 million, an increase of 298.7% for the one-year period and up 294.8% from five years ago.
Despite the decline in overall investment in hedge funds found by P&I's analysis, sources said institutional investors, by and large, are maintaining, fine-tuning and fortifying their hedge fund portfolios as part of efforts to protect their portfolios against expected down market conditions in 2019 and beyond.
By way of fine-tuning, asset owners are both hiring new managers and culling those hedge funds that no longer fit within their portfolio structure or are underperforming. "The very big picture shows that a lot of big public pension funds are allocating and reallocating money to the best managers in a strategy while others are looking to hedge funds to diversify their portfolios and are hiring new managers," said Donald A. Steinbrugge, CEO of Agecroft Partners LLC, a Richmond, Va.-based consulting and third-party marketing firm specializing in hedge funds and other alternative investments.
Other observers stressed that asset owners are looking to hedge funds to provide downside protection for their whole portfolio as volatility rises across global markets.
"There's a big appetite among asset owners for risk-controlled strategies in public markets. They are re-evaluating their equity exposure and deciding what to do in a market that will have more volatility and less certainty," said John P. McCormick, president and CEO of Blackstone Alternative Asset Management, New York.
BAAM managed $80 billion in hedge funds of funds, co-investments, customized separate accounts and other alternative investment approaches as of Sept. 30.
Direct investments in hedge funds were down 6.1% to $8.197 billion this year compared to 2017 but were up 12.2% from 2014.
Investment in hedge funds of funds totaled just $280 million from two pension funds, down 74.5% from 2017 and down 92.3% from 2014, P&I's analysis showed.
Actual annual investment and redemption in hedge funds and funds of funds by institutional investors might be larger because many institutional investors do not disclose their investment activities.
Among the asset owners that continued to build their hedge fund portfolios throughout the year:
- The $57 billion Pennsylvania Public School Employees' Retirement System, Harrisburg, invested a total of $1 billion in five hedge funds and $200 million in a hedge fund of funds.
- The $24.5 billion San Francisco City & County Employees' Retirement System invested a total of $895 million in nine hedge fund managers through a customized separate account jointly managed by internal investment staff and Blackstone's alternative asset management division. SFERS has earmarked $3 billion for direct investment in hedge funds through the limited partnership vehicle set up with Blackstone.
- As part of moving to direct investment in hedge funds, the $29.1 billion Texas Municipal Retirement System, Austin, redeemed $610 million from a customized hedge fund-of-funds portfolio and deployed $500 million of the proceeds with investments in three hedge funds.
P&I's analysis found fewer large terminations than large hires, led the by $12.3 billion Kentucky Retirement Systems, Frankfort, which terminated six hedge fund managers with total assets of $216 million as part of its well-publicized 2016 decision to restructure its hedge fund portfolio.
The $51.8 billion Teachers' Retirement System of Illinois has been active this year in terminating hedge fund managers whose strategies no longer were performing optimally within the fund's $2.7 billion hedge fund portfolio.
The fund terminated two managers running a total of $526 million, the largest total termination of hedge fund managers in P&I's universe of asset owners.
TRS investment officers, who have investment discretion, also added new hedge fund managers, allocating a total of $930 million to five new managers.
As for future hedge fund activity by institutional and retail investors, sources said the extremely tough investment environment hedge fund managers have endured in 2018 likely will result in negative returns and net redemptions as the year ends.
The HFRI Fund Weighted Composite index returned of 1.45% in the nine months ended Sept. 30, compared to 5.7% for the nine months ended Sept. 30, 2017. But conditions worsened as sharp volatility hit global markets in October, resulting in a decline of 3.12% for the index in the month. Combined with a dip of 0.16% in November, the index was down 2% year-to-date through Nov. 30. The HFRI indexes are managed by Hedge Fund Research Inc.
Modest net redemptions are expected to continue in 2019, said sources, including Luke Ellis, CEO of Man Group PLC, London, who noted that rolling 12-month returns are reasonably predictive of hedge fund industry flows.
"The environment over the last two to three months increases the chances of net redemptions from all investors in the first and second quarter of 2019. If performance doesn't improve, redemptions may continue into the third and fourth quarters," Mr. Ellis said.