Managers see good times ahead in 2021

Prospects for the hedge fund industry a year after the COVID-19 outbreak are strong given good performance, the first positive flows since 2018 and plenty of market dislocation providing opportunities for alpha production.

"2021 is shaping up to be a very good environment for hedge funds as managers focus more on fundamentals," said John F. Frede, managing director and head of research at 50 South Capital Advisors LLC, a Chicago-based alternatives funds-of-funds manager.

"Portfolio managers of long/short equity hedge fund strategies, for example, are taking advantage of market disruption and dislocation. It's really a very good environment for stock pickers," Mr. Frede said.

50 South Capital had a total of $10.5 billion in assets as of Dec. 31, with $6.9 billion of assets under management and the balance in assets under advisement.

Sources said the outlook for the hedge fund industry this year remains positive despite plenty of headline risk and general skepticism resulting from the market turmoil caused by retail trading in stocks like GameStop Corp. in January and high losses incurred in March by family office Archegos Capital Management LP. Archegos' losses have broadly been labeled as hedge fund problems.

A hedge fund consultant who asked not to be named referred to both incidents as "a flash in the pan," noting that they were painful but short-lived and markets quickly recovered.

"These were good reminders that everybody needs to be cognizant of leverage, risk concentration and illiquidity," the consultant said.

Like other hedge fund and hedge funds-of-funds managers, 50 South Capital is seeing net inflows from both new and existing clients, as are AQR Capital Management LLC, Greenwich, Conn.; Capstone Investment Advisors LLC, New York; and Man Group PLC, London, the firms said.

Regarding asset owners' current and future hedge fund allocations, "the question institutional investors are asking is 'did hedge funds do what they are supposed to do and mitigate risk when the equity market was down 20% in the first quarter last year?' The answer is yes," said Daniel Stern, a senior managing director at alternatives consultant Cliffwater LLC.

In contrast, Cliffwater clients' hedge fund portfolios were down 4% to 5% in the tumultuous first quarter of 2020, Mr. Stern said.

He added that "hedge fund alpha (production) has been very strong since April last year and continues in 2021. We think alpha will be persistent for several years."

That said, Mr. Stern said industrywide he's not seeing "big asset allocation changes into or out of hedge funds. Most plan sponsors are conducting business as usual, rebalancing as needed and adding modestly to existing hedge fund strategies. I haven't seen any reductions, but on the other hand, I'm not seeing broad moves generally into hedge funds."

Performance remains strong in 2021 after the HFRI Fund Weighted Composite index returned 11.8% in the year ended Dec. 31, the best return in a decade, data from Hedge Fund Research Inc., Chicago, showed.

By comparison, in the year ended Dec. 31, the S&P 500 Total Return index was up 18.4% and the Bloomberg Barclays U.S. Aggregate Total Return index was up 7.5%.

Year-to-date through Feb. 28, the HFRI index was up 5.3%, supporting expectations that "the outlook for the hedge fund industry in 2021 is very positive," said Kenneth J. Heinz, HFR's president.

Net inflows into hedge funds are "following better performance and there is more return dispersion among hedge fund managers than I've seen for a couple of years," said Peter Laurelli, eVestment LLC's global head of research.

Year-to-date through Feb. 28, net inflows totaled $23.7 billion, up from net outflows of $59.3 billion in all of 2020 and $102.3 billion in 2019, eVestment data showed.

EVestment doesn't break out net flows from institutional investors, but analysis of P&I's reported hedge fund activity by asset owners through March 26 found that $1.8 billion was invested in hedge funds and hedge funds of funds and $31 million was redeemed. By comparison, $1.4 billion was invested and $230 million was terminated from hedge funds/hedge funds of funds in first quarter 2020.

Hedge fund and hedge funds-of-funds managers expressed optimism about 2021, not only because of favorable market conditions, but also due to nascent interest from institutional investors in using hedge funds as a possible portfolio replacement for low-returning fixed-income strategies that are becoming too correlated to public equity returns.

"There has been lots of debate going on about inflation this year and asset owners also are worried about the funding challenges for defined benefit plans in the current low-interest-rate environment," said Luke Ellis, CEO of Man Group.

Those inflation-oriented conversations with Man Group clients in turn have led to "more bond-replacement conversations in the last four months than we've had in a very long time," Mr. Ellis said.

The situation "creates a good opportunity to substitute market-neutral hedge funds (for fixed income because they) ... offer a bond-like return of between 5% and 10%, low volatility and generally low drawdowns," Mr. Ellis said, noting that Man Group is seeing "really strong demand for market-neutral hedge funds." He declined to provide specific asset flows.

Man Group managed $123.6 billion as of Dec. 31.

Mr. Frede said 50 South Capital's institutional investors also are looking for a substitute for traditional long-only investment-grade bond strategies and are evaluating the firm's credit hedge fund strategy, which features very short duration and low interest-rate sensitivity.

Paul Britton, CEO of volatility and tail-risk manager Capstone Investment Advisors, said the firm also is seeing "very strong demand" for its hedge fund strategies as investors shift away from bonds.

"The utility of fixed income currently is compromised. There's not an awful lot of yield protection or diversification available for investors in traditional bonds," he said.

Capstone also is seeing "a big steady stream of net inflows into the firm's tail-risk portfolio so far this year because, ultimately, there is a need for investors to protect large institutional portfolios," Mr. Britton said.

Mr. Britton said he could not provide specifics about net inflows so far this year. Capstone managed $9 billion as of March 31.

Balyasny Asset Management LP, Chicago, closed its multistrategy hedge funds to new investors last year after experiencing high inflows from the second quarter onward and remains closed despite "accelerated demand" this year, said Scott Schroeder, co-founding partner and head of the client relationship group/business development.

Balyasny's flagship fund returned 33% in 2020 and likely is one of the reasons asset owners were keen to invest in the fund, a source said.

Balyasny managed $10 billion as of March 31.

After a tough 2020 in which AQR Capital Management's total assets declined 24.7% to $140 billion, the firm is seeing renewed interest from institutional investors in its hedge fund strategies, thanks to much improved performance in the first quarter.

For example, AQR's absolute-return strategy, a broad multistrategy hedge fund, was up an estimated 22% in the quarter ended March 31, compared with 1.2% in the year ended Dec. 31.

The AQR Diversified Arbitrage Fund was up an estimated 6% in the first quarter after a one-year return of 25% in 2020.

David G. Kabiller, an AQR co-founder, principal and head of business development, said there had been outflows from the firm's hedge funds in 2020 but noted that so far this year "flows tend to follow performance and we are seeing increased institutional investor interest and modest inflows … and we expect this to continue as performance continues to accelerate."

Mr. Kabiller declined to provide the size of net inflows in 2021.