Asset owners finding reasons to be bullish about hedge funds

It's been a while, but hedge funds are interesting again. Rising rates, increased volatility and persistent inflation have created dispersions across both equities and credit, giving hedge fund managers something to trade.

Investors also are taking a renewed look at hedge funds as they look for ways to take advantage of new investment opportunities and position portfolios more defensively. Yet, despite these tailwinds, hedge funds remain under pressure.

Hedge fund performance is hardly a monolith. Last year, hedge funds were down 4.14% (vs. returning 10.16% in 2021), according to the HFRI Fund Weighted Composite index, but that doesn't mean they were down in every portfolio. And the variance in return is creating unique dynamics for institutional investors. Year-to-date through Sept. 8, the index is up 4.7%.

"At a high level in the institutional space, there are some clients who are taking a fresh look at hedge funds having either not invested or reduced allocations in the recent period up until last year," said Jack Springate, co-head of the external investing group hedge fund strategies business at Goldman Sachs Asset and Wealth Management. "There are also some clients in the institutional space who have had hedge fund allocations that outperformed the rest of their portfolio by such a degree last year that they had to rebalance. It's the first time in my career I've seen investors redeem from hedge funds after really good performance because of a need to rebalance in this way."

Steven Wilson, director, public markets, at the $185 billion Austin-based Teacher Retirement System of Texas, who is responsible for the system's $9.1 billion stable value hedge funds portfolio, said in emailed comments that the "market-neutral hedge fund program made over $700 million last year. We sent all of that plus another $900 million back to the pension plan to help meet cash needs and fund new beta sensitive investments that were 'on sale.' We have not changed our strategy mix but the bar for a new manager is higher now. With our program at target, there is less hiring in general, and the incumbent managers that survived last year's culling are among the strongest in the industry."

Bill Li, MassPRIM's director of portfolio completion strategies, also reported positive hedge fund performance (4.5%) in the latest fiscal year, but has observed performance gaps over the past year that have been significant, he said.

"During the past year, the hedge fund industry itself had been trying to navigate a chaotic market," Li said in comments last month to the Massachusetts Pension Reserves Investment Management's board, shared with Pensions & Investments. "Despite a flat industry return measured by HFRI Asset Weighted Composite, underneath the surface, dispersion was tremendous. To put that into a context, year-to-date alone, the gap between the average top-decile performer and the average bottom-decile performer had been as high as 36%. Against this dispersed reality, for hedge fund investors like us, manager selection is absolutely critical, Li said.

Boston-based MassPRIM has about $96.6 billion in total assets and about $7.4 billion in hedge fund assets.

Rising interest rates and market volatility are creating the kinds of conditions that are typically a net positive for active managers because they can lead to mispricings or dispersions within the credit market that allow for opportunistic trades. These conditions are also giving investors a surprising upper hand. Cash positions in portfolios are now yielding over 5%, meaning hedge fund managers have to go further to prove their value, and investors are less willing to pay performance fees for cash-driven returns.

Investors are likely to expect more out of hedge fund returns, and if those returns are being driven by the cash rate, redemptions could follow.

"Fed policy stifled volatility and alpha in the 2010s. This has reversed, and we've seen hedge fund alpha pick up significantly. This is a good reason to be bullish on hedge funds over the medium term," Texas Teachers' Wilson said. "The problem is, cash is now a compelling competitor, especially to market-neutral hedge funds. Making 7% for investors and taking a victory lap is not going to cut it anymore. We need to see healthy premiums to cash to stay interested in the complexity and cost of these investments."

Goldman's Springate said the current market regime could keep pension funds interested in hedge funds.

"The environment right now should be broadly supportive for all types of hedge fund strategies, because higher dispersion should be good for active management," he explained, adding that the desire for diversification could keep some strategies in favor.

"There are some strategies that are typically more diversifying than others such as equity market-neutral or quant market-neutral, macro strategies, and different kinds of relative value strategies. If investors are particularly focused on maximizing portfolio diversification, there may be greater interest in these strategies in order to build less correlated, low-beta portfolios that will have a different type of return profile," he said.

MassPRIM is considering similar strategies. "In terms of hedge fund category contributions, event-driven strategies and relative value strategies continued to be the biggest return drivers," Li said in the comments to the board. "This is in line with our desire for unique returns, which are innately the nature of event-driven and relative value. And we continue to embrace both as reliable sources of diversifying return streams. Looking ahead, the team's sourcing focus continues to be on special situations/distressed managers, which fall under the event driven category."

Investors are also using their hedge fund programs to find the next generation of skilled managers and unique sources of return.

Canada Pension Plan Investment Board's emerging manager program looks for new hedge fund managers that have the ability to make unique, usually smaller bets and outperform.

"Our mandate is to look for uncorrelated returns, and we think allocating to emerging managers helps us achieve that to a better extent," said Yan Kvitko, managing director, external portfolio management at CPP Investments, which manages the assets of the C$575 billion ($433.6 billion) Canada Pension Plan, Toronto. "This is in part because we think the returns can be higher at the initial stages when managers are first launching and also because we can negotiate more attractive terms. The other factor is related to scalability and our desire to scale our portfolio and be able to grow over time as the portfolio grows as well. So we're essentially securing capacity with interesting managers and strategies."

CPP Investments has been making, on average, three investments every year in emerging managers with initial allocation sizes between $50 million and $300 million and an eye toward doubling or tripling that investment within a few years, Kvitko said. "We've made approximately 20 investments since we started the program and it has grown to a meaningful percentage of the overall portfolio that we have in hedge funds," he said.

The program's recent investments have included credit long/short funds and event-driven funds. "We recently did a couple of investments in the quant space and in systematic strategies," Kvitko added. "We also invested in a fairly new, new developing area, which is carbon credit trading. I wouldn't say that there's a specific strategy right now that we are prioritizing or think is a lot more exciting than everything else."

CPP Investments has also recently partnered with a third-party operations provider to create an outsourced operations platform for emerging managers. The platform allows emerging managers to offload some of the business operations overhead that comes with starting a new fund so that they can focus on investing.

Kvitko said the platform gives the fund manager an institutional-level infrastructure that the pension fund "knows it can trust" but also lowers the barriers to entry for managers that might not otherwise be under consideration.

"The idea is we invest with them in this structure for about a year, and then if things are going well, we look to size them up. Managers find it interesting because we are still looking to scale with them and they are able to attract other investors and grow their business at the same time," he said.

As of June 30, CPP Investments had C$60 billion deployed across 60-plus alternative asset managers, most of them hedge funds, with C$8 billion allocated to emerging managers specifically.

At the consultant level, the search for fresh sources of alpha is also underway. Chris Walvoord, global head of alternatives portfolio management and research at Aon, is finding new opportunities in asset-backed finance strategies that offer uncorrelated returns.

"We've had some success looking in the nooks and crannies finding interesting opportunities in things like carbon credits, mortgage servicing rights; we're looking at a diamond finance fund," he said. "Those are strategies that can come alongside other more traditional funds and act as diversifiers."

Victoria Vodolazschi, senior investment consultant for hedge funds at Willis Towers Watson, added that now is a good time for investors to look at their overall portfolio construction and understand what exposures they have and make allocations that are going to be value additive overall.

"We encourage our clients to think longer term when it comes to hedge funds and all asset classes really," she said. "There are strategies that are going to be more cyclical in nature. There are strategies that are going to be more opportunistic in nature. There are strategies that are less correlated to the market. You can bring these properties together based on the goals of the portfolio. I think that's where hedge funds prove they deserve an allocation especially during times of more macro noise and more insurgency in the market."