Investors Rebalance Their Hedge Fund Portfolios

Extract from Preqin Investor Outlook: Alternative Assets H1 2019

Preqin
Originally published in the April | May 2019 issue

2018 was a challenging year for hedge funds: a difficult Q4 for performance, coupled with a net $34bn being withdrawn from hedge funds, resulted in AUM dropping over the last six months of the year to $3.45tn as at December 2018. However, the industry is still 3x the size it was a decade ago, as investors recognize the ability of hedge funds to act as a portfolio diversifier and risk mitigator. 

Following the Global Financial Crisis (GFC), faced with the prospect of not meeting long-term liabilities, many institutional investors turned to hedge funds and capital flowed into the asset class. Over the second half of this decade, however, capital entering the asset class has slowed and there are signs industry AUM may have begun to plateau. The rush to build up portfolios has slowed as many investors have reached their desired level of exposure. Our results reveal that four out of five investors plan to maintain or increase their exposure to hedge funds in 2019. We also expect investors to redeem and rebalance in favour of less correlated strategies to ensure capital is protected in the event of a downturn.

The outlook for 2019 is therefore nuanced. While the slowdown in growth may indicate a lack of activity, beneath the surface we expect high levels of movement of capital. Whether hedge funds can deliver this for investors will be crucial in 2019, and managers must recognize the specific needs of each investor and be able to adapt to them.

Key Survey Findings 

55%

of hedge fund investors were disappointed with the performance of their portfolios in 2018

42%

of hedge fund investors believe stock market volatility is the biggest threat to return generation in 2019

61%

of alternative assets investors believe we are at the peak of the equity market cycle

79%

of hedge fund investors plan to increase or maintain their allocation to hedge funds over the longer term, the largest proportion since December 2013

40%

of hedge fund investors are planning to position their portfolios more defensively in the year ahead

29%

of hedge fund investors are looking to increase their exposure to macro strategies over the next 12 months

1. Views on performance

Back at the end of 2017, investor satisfaction with the performance of hedge funds was at its highest level since the end of 2013; following 12 consecutive months of positive returns, the Preqin All-Strategies Hedge Fund benchmark ended the year on +11.99%. 

Fast-forward one year, however, and investor sentiment has changed following a turbulent year for both hedge funds and the wider global economy. Hedge funds lost 3.41% over 2018, and more than half (55%) of surveyed investors told us the performance of the asset class fell short of their expectations (Fig. 1). 

However, high absolute returns are not the primary motivation for investing in hedge funds for the majority of investors, and many look to hedge funds to provide downside protection in times of market volatility. While returns were down, the losses were not as severe as those seen in equity markets, and the volatility of hedge funds (4.28%) was much lower than that of the S&P 500 PR Index (15.30%). With this in mind, over half (57%) of investors remain confident in the ability of hedge funds to meet their portfolio objectives; over the past year, 16% of investors have become more confident in the asset class (Fig. 2), up slightly from 14% that said the same at the end of 2017. 

Looking ahead, 37% of investors believe the performance of their hedge fund portfolios will improve over the course of 2019, while only 17% think performance will be worse than in 2018 (Fig. 3).

2. Current challenges

Investor sentiment is turning increasingly bearish towards equity markets; the volatility that bookended 2018 is at the forefront of institutional concerns. The largest proportion (42%) of investors believe that equity market volatility will continue into 2019 and will be a key challenge to hedge funds’ capabilities in generating returns (Fig. 4). 

This very volatility may prove to be the wind in the sails of many hedge fund strategies, though, many of which are designed to thrive in times of market turbulence. Numerous hedge fund managers have blamed the extended growth and calm across markets as a hindrance to performance in recent years. 

A growing pool of investors think we are at the top of the equity cycle and, with this in mind, are looking to position their hedge fund portfolios more defensively in the event of a market crisis or correction (Fig. 5).

Although hedge funds as a whole were caught out by the volatility at the end of 2018, many have reduced their long-only exposure in recent months and other strategies show negative or no correlation to market direction. As a result, we may see investors rebalance portfolios in favour of hedge funds in 2019, especially less correlated strategies.

3. Plans for next 12 months

Over the next 12 months, a significant 79% of investors plan to invest the same amount, or more capital, in hedge funds as they did in the previous 12 months – this is the largest proportion we have seen since the end of 2014 (Fig.6).

Macro strategies favoured

A notable 29% of investors are planning to increase their exposure to macro strategies in the coming year, the largest proportion across all strategies (Fig.7). 

With investors generally looking to rebalance their portfolios in 2019 in favour of defensive strategies, those with less correlation to market beta such as macro strategies, systematic CTAs and market neutral strategies may see inflows. 

US leads for investors

Sixty-nine percent of surveyed investors plan to predominantly target developed markets over the next 12 months, whereas just 6% intend to place the majority of their 2019 capital in emerging markets, and a quarter will take a mixed approach (Fig.9). 

Over three-quarters (77%) of investors feel the US presents the best opportunities, the largest proportion across all alternatives (Fig.10). 

Western Europe (excluding the UK) was cited by 37% of investors, while the UK specifically was named by 24%. Japan is viewed favourably by 22% of investors.

Among emerging markets, Asia is likely to receive the most hedge fund capital in 2019. China was the emerging market named by the largest proportion (47%) of hedge fund investors as presenting favourable investment opportunities (Fig.11). India and other regions within Emerging Asia were each named by 25% of investors. 

Uptick in managed accounts

Pooled vehicles remain the preferred route to market, targeted by 70% of investors in the year ahead, as they typically meet investors’ needs and allow for a diverse portfolio of investments. However, greater control over investments is increasingly important; using the latest Form PF data, hedge funds’ aggregate value in parallel managed accounts has grown from $619bn at the end of Q2 2016 to $770bn at the end of Q1 2018. 

Outlook for 2019

The market volatility endured at the end of 2018 will be at the forefront of investors’ minds as we move through 2019. Investors were largely unsatisfied with performance of their hedge fund portfolios over the course of the past 12 months, and in previous years this would likely have led to large outflows. However, it is the benefits that a hedge fund portfolio can offer for capital protection going forwards, rather than poor returns in the past, that will drive investors’ plans in 2019. Beyond 2019, a significant 29% of investors plan to increase their allocation to the asset class over the longer term, the largest proportion since 2015 (Fig.12); on the other hand, 21% of investors plan to reduce their hedge fund allocation, which is the smallest proportion we have seen since 2013. Attracting investor capital will of course still be challenging and fund managers must understand each individual investor’s needs in order to win capital.