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Hedge funds strike back after a lost decade

The level of alpha that hedge funds generated in the age of quantitative easing was "lackluster", but rising market volatility now offer "a richer opportunity set for skilled managers."

Hedge funds are back in action after a decade of decay, according to the latest report on the industry from WTW (formerly Willis Towers Watson). Hedge funds in today’s bear market have significantly outperformed equities, with average returns of -5.6 per cent between January and June 2022 compared to broader equity market declines of – 20.5 per cent on the MSCI World Index.

It’s not as strong a result as seen in the Dotcom crash, where hedge funds almost avoided a negative return while markets fell by nearly half, but it’s one that “offers a striking parallel” to the downside protection seen from hedge funds during the early 1990s, when they successfully navigated the oil shock and subsequent recessions caused by the invasion of Kuwait.

This serves as a reminder of the potentially powerful role of hedge funds in portfolios, particularly in today’s market conditions of high inflation, a challenged macroeconomic outlook and the ongoing war in Ukraine,” the WTW report says.

Hedge funds have also retaken the lead on funds management innovation, branching out into areas “ripe for exploitation”, including digital assets and carbon credits,  “full of volatility… and requiring investment skill.”

“We are convinced that by embracing innovation and sustainable investing best-practices, the hedge fund industry can take a leap forward in its client value proposition, establishing a sector that will better reflect our society and deliver better performance outcomes for savers,” said Sean Hollins, head of liquid diversifying strategies for WTW in Australia (photo at top).

“We have been encouraged by the progress made by the hedge fund industry in recent years, including the strong performance contributions to institutional investors’ portfolios and downside protection provided in periods of falling equity markets. There is a fantastic opportunity for hedge funds to continue recent positive momentum and remain highly relevant to investors.”

But WTW found plenty of downsides too, foremost among which was a failure to engage on inclusion and diversity. Routes to entering the industry are different to what they were two or three decades ago, when the talent funnel was “extremely narrow” – the vast majority of hedge fund professionals came from bank analyst programs and bank proprietary teams, leading to fairly uniform team composition. While entry into hedge funds is now more diversified, with the GFC seeing a dramatic reduction in size of proprietary trading desks, it remains “extremely difficult”.

“There are potentially more appealing career paths for juniors and graduates emerging in other areas of asset management, and in external industries such as the technology sector,” the WTW report says.

“Here, possibilities for wealth creation seem to be coupled with a better work-life balance and a more inclusive and equitable workplace (although, we acknowledge there are examples of technology companies getting it wrong); hedge funds are faced with a worrying trend of diminishing talent in their pipelines.

The other downside is the re-emergence of excessive fees and opaque cost structures, with WTW starting to see upward pressure on hedge fund fees and growing discussion of a fee structure that it is “very concerned about”: hedge funds that are set-up as expense pass-through platforms.

“In principle these structures sound great: investors pay what it costs to run the fund, plus a performance fee when good performance is delivered. In the event of a challenging performance period, costs are still covered, giving investors confidence in the stability of the firms trusted to look after their assets,” the report says. “However, there is a material misalignment of interest: how can the costs be controlled and what is the incentive to do so?”

“For example, platforms hire portfolio managers and their entire teams, pay them whatever is needed and allow them to spend whatever they want to generate returns. But this does not guarantee results. If a team does not generate performance immediately, their allocation within the fund is quickly cut, and if this continues, they are fired. All associated costs are charged to investors.”

WTW has seen management fees that exceed eight per cent per annum, with performance fees on top, and is concerned about the “detrimental impact on outcomes over the medium-term” that derive from a focus on short-term performance. Due to relatively good performance and marketing, some of these hedge fund platforms are currently enjoying significant growth in AUM – enticing more hedge funds to switch to the business model. WTW believes this would represent “a backward step for the industry.”

“We would encourage the investors allocating to these hedge funds utilising the expense pass-through model to question whether they are getting value for money, the effectiveness of the alignment of interest and the longer-term longevity and stability of this model,” the report says.

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