Recent decisions by two large U.S. public pension plans to pull back from hedge fund investments, and the likelihood of a sixth consecutive calendar year of return averages underperforming broad equity market returns, are not expected to curb investors’ overall allocations to hedge funds, says Fitch Ratings.
Barring an unforeseen major market decline, it expects hedge fund assets under management (AUM) in the United States should continue on a path toward US$3 trillion, good growth relative to 2013’s year-end level of US$2.6 trillion. The rise is attributable to market appreciation and inflows outpacing redemptions. The AUM flows show significant variation by strategy, with equity-oriented funds attracting more capital in recent periods but global macro funds falling from favour.
Read: Hedge funds post gains
“While hedge fund growth has certainly slowed over the past several years, the high-profile pension plan withdrawals seen over the past six weeks are not representative of broader sector trends, in our view,” says Fitch.
The most visible withdrawal occurred when the California Pension Employees’ Retirement System’s (CalPERS) cited complexities and cost considerations as key drivers behind its exit from hedge fund investments.
Read: What does CalPERS’ hedge fund decision mean for ETFs?
A smaller but still high-profile decision followed when the US$20-billion San Francisco Employees’ Retirement System (SFERS) decided not to allocate 15% of its portfolio to hedge fund investments; a decision spurred by consultant conflicts and opinions shared between Warren Buffet and SFERS trustees.
Fitch believes that continued allocation the hedge fund investments more broadly speaks to investors’ belief that hedge fund investments can often deliver competitive returns net of fees, while providing a degree of downside protection and uncorrelated return during periods of stress.
Over the past decade and a half, hedge funds have delivered steadier performance relative to the overall market during bear markets, as was seen in 2000 to 2002 and in 2008. This downside protection, however, comes at the expense of limited upside during bull markets, a trend seen in 2003, 2009 and especially 2013.
Read: Hedge funds on the rebound
Fitch believes that when large sustained differences exist between what is achievable through indexing and what is achievable through hedge funds, pressures on hedge fund flows and fees can mount. This, combined with only modest restrictions on redemptions, is among the attributes that tend to result in lower ratings assigned to hedge fund investment managers relative to broadly diversified alternative investment managers.
In some regards, hedge funds could potentially benefit from a material correction in the markets, if their performance avoids surprises and delivers uncorrelated performance with the market correction.