Return of the hedge fund

• Jean Baram, managing director, investor relations, Innocap Investment Management
• Ryan Bisch, Canadian alternatives boutique leader, Mercer
• François Bourdon, associate chief investment officer and vice-president, asset allocation and fixed income, Fiera Capital
• Martin Gerber, president and chief investment officer, Connor, Clark & Lunn Investment Management Ltd.
• Ian Struthers, partner and investment practice director, Aon Hewitt

Are hedge funds making a comeback among institutional investors?

Ryan Bisch: The raw data would suggest it’s a bit early to call it a “comeback.” That said, as investors look to improve the diversification of their investment portfolios, both at an asset class level and in terms of the exposure to underlying return drivers, the topic of hedge funds continues to be an increasingly important part of the conversation. In Mercer’s opinion, hedge funds have a specific and critical role in institutional investment portfolios.

Ian Struthers: It is fair to say that there is interest and discussion on hedge funds and their role in a portfolio, but we have yet to see a lot of demand from clients to implement these strategies—certainly not to the extent we are seeing outside Canada. There is more of a priority among Canadian institutional investors on building out their illiquid alternatives exposure using real estate and infrastructure.

François Bourdon: Non-traditional strategies in general are appealing to more and more institutional investors that are looking to dampen their downside risk. The hedge funds with the most appeal among institutional investors are those that are transparent, contain simple strategies and boast consistent returns for their clients.

Jean Baram: Simply based on assets under management, it is true that the assets in the industry are at an all-time high, and that can be seen as a comeback following the losses posted during the 2008 financial crisis. However, when taking a more granular view, we observe that the industry has experienced significant changes after the crisis. While investors were mainly funds of funds, family offices, high-net-worth investors and private banks, the demand in the industry is now predominantly driven by pension plans and other institutional investors. These investors are allocating more to hedge funds than in the past, as the 2008 crisis awakened their need for diversification and downside protection.

From our perspective, the crisis has generally led to an increase in demand from institutional investors for hedge funds (and not a decrease—thus not a comeback per se). These investors have changed the way they invest, switching from the traditional fund of fund model to direct investment and, more specifically, via managed accounts. However, the other groups of investors that reduced exposure to hedge funds after the crisis have been reluctant in increasing their allocation to the space.

From a pension fund’s perspective, what are the risks involved with investing in hedge funds?

Bisch: Hedge funds are risky investments, not unlike traditional stocks and bonds. Hedge fund risks, however, can be more difficult to identify and manage, given the general opacity of the investment vehicles and the complexity of the strategies traded. The key to successful hedge fund investing is to identify and diversify or avoid those hedge fund risks that are non-compensating and accept those risks that are expected to reward with attractive risk-adjusted returns.

Non-compensating hedge fund risks include business risk. A pension fund would not invest in a single stock to gain exposure to large cap equities, for instance—yet we have seen some plan sponsors make this very mistake with their hedge fund allocation. The result is that the business risk of the individual hedge fund becomes the dominant risk, swamping the potential benefits. This situation is easily solved, however, through diversification across multiple hedge funds—exactly the approach investors take with traditional stocks and bonds.

Baram: When investing in hedge funds, pension funds face similar risks as those they face in traditional funds, such as market risk, geopolitical risk, operational risk, fraud risk, blow-up risk, liquidity risk, etc. Due to the nature of hedge fund investing, they face additional risks such as diversification risk, credit and counterparty risk, and leverage risk, as well as reduced regulatory supervision. This has given rise to the popularity of managed account structures, as they mitigate some of these risks.

Martin Gerber: A key challenge sponsors face is the difficulty of finding managers with the necessary skill to produce consistent active returns. In assessing past performance to select active managers, it is quite difficult to discern true skill from luck.

What are the possible benefits?

Bisch: When properly implemented, hedge funds can provide exposure to non-traditional risks that diversify and complement traditional stocks and bonds. By diversifying the drivers of return beyond equity market risk and interest rate risk, the portfolio enjoys multiple drivers for potential success, achieving superior diversification. This diversification may be particularly timely today, given where we are in the interest rate cycle.

Historically, investors have sought to mitigate equity volatility with high-grade fixed income. High-grade fixed income securities, however, are priced for disappointing prospective returns, enhancing the allure of an alternative to traditional investments.

Gerber: The main benefit hedge funds bring to pension plans is the potential for uncorrelated returns. Much of this diversity arises from active investment strategies used by hedge fund managers. This additional diversity can be used to reduce volatility or to increase returns.

Baram: Pension funds gain important benefits through hedge fund investing, such as access to broader strategies, better usage of each dollar deployed (via leverage and notional funding), improving the risk/return profile of their investment, diversifying their portfolio or reducing the drawdowns.

Are funds of hedge funds over, or do they still offer opportunities for pension investors?

Gerber: I believe that the original funds of hedge funds model is challenged in a couple of ways. For investors, many of the fees-on-fees structures were too costly. For hedge fund managers, the pressure funds of hedge funds face to add value by managing managers resulted in them being unreliable sources of capital. That said, if these issues can be addressed, there is still a need for good advice in this segment of institutional investing.

Struthers: Contrary to many industry observers, we do not believe that hedge funds of funds are on the way out and that in the right situation they can play an important diversification role in a Canadian portfolio. Some of the advantages of using these products include immediate strategy and manager diversification, a more streamlined governance and monitoring model for investors, an ability to customize mandates for larger allocations, access to otherwise closed products, an ability to negotiate terms and fee structures with underlying managers, and attractive risk adjusted returns. Manager selection for the fund of funds provider is critical. For certain institutional investors making their first foray into a hedge fund allocation, there is a preference for hedge funds of funds for all of the reasons listed above.

Bisch: From a Canadian investor’s perspective—given the size and internal resources of the typical Canadian pension plan—I expect funds of hedge funds to remain relevant. That said, the funds of hedge funds model can be one of the key implementation hurdles to overcome when considering an allocation to hedge funds.

Bourdon: Funds of hedge funds can still offer value to investors that are not in a position to make individual selections and that are looking for further ways of managing risk. In addition, for funds where governance is a key consideration, funds of funds are still attractive to gain access to the asset class. The additional layer of fees is, however, an important consideration, so multi-strategy funds—which typically have only a single layer of fees—become of greater interest.

Jean Baram: Funds of hedge funds have reinvented themselves to adapt to the changing environment. Consultants are trying to fill some of the void that occurred after investors redeemed from funds of hedge funds due to poor performance in 2008. In response, many funds of hedge funds have reduced their fees. Some have moved away from the multi-strategy diversified offerings. Many have concentrated their holdings (i.e., less funds in the portfolio). Some moved into the emerging manager space to differentiate themselves from consultants and some are also focusing more on bespoke or advisory mandates.

The wave of consolidation that this part of the industry has experienced has been part of the effort to fulfill some of these new areas of growth. There should be continued demand for funds of hedge funds going forward, especially from smaller pension funds that will use them as a way to have exposure to the market, while others will use them to get exposure to niche strategies like emerging programs.

For those investors that have been let down by hedge funds before, how can they prevent this from happening again?

Baram: Generally, the performance of the hedge fund industry in the last few years did not meet investors’ expectations. However, many hedge fund strategies performed well. Like many investments, past performance is not indicative of the future, so a thorough due diligence process aimed at understanding the strategy, its drivers, favourable and unfavourable environments, and the manager’s investment process is key for investors.

Bisch: There is no inexpensive, passive means for implementation (at least, not one that has proven its mettle over market cycles), and implementation risk is high in selecting managers and constructing portfolios. We observe that some investors seek to minimize costs through a do-it-yourself approach. Ironically, we have observed far more capital destroyed through inexperienced allocating than through the cost of seeking professional advice.

Bourdon: The most important element would be to thoroughly understand the investment strategy in question, in order to be able to identify the market environments where the fund should perform well or experience some form of difficulty. This would lead to more realistic expectations regarding said strategy. For example, a credit strategy that would be expected to perform well under normal circumstances should not be expected to perform well in a crisis-like environment such as the one encountered in 2008.

Struthers: Hedge funds should be included in portfolios but investors need a clear understanding of their role in the overall portfolio. Once determined, they can then decide which strategies best accomplish this goal. Extensive due diligence should be performed to understand key characteristics or risks, such as size, quality of transparency, independent directors, sustainable competitive advantages, a track record of executing against their strategy, and the strength of the firm’s risk controls, compliance, and operations. As such, working to understand the strategies of the hedge funds considered and how they complement each other (and other investments) to maximize return and minimize volatility is a critical part of portfolio construction.

What trends are emerging in the hedge fund space?

Bisch: We continually see new trends emerge that are intended to solve the problems associated with hedge fund investing, such as highly liquid offerings, mutual fund hedge funds and low-cost approaches. While there is certainly a healthy dose of demand for such solutions, it is interesting to note that such breakthroughs are not new but are recycled versions that have previously disappointed in past incarnations. It strikes us that many investors are trying to solve for the wrong problem, looking for a more liquid or cheaper product, when the problem they should actually attempt to solve for is manager selection. We believe the future will demonstrate that well-structured hedge fund allocations offer an attractive alternative to traditional stocks and bonds.

Baram: We have seen many trends slowing down, such as the interest in structured credit and credit managers. On the other hand, we are seeing the continuation of some trends, such as more variations of managed account structures, a big wave of hedge funds being offered to retail and more concentration in client portfolios (i.e., fewer hedge fund managers). Generally, investors should expect more changes and regulations, and these changes will lead to opportunities. For example, due to increased regulatory scrutiny, banks are exiting some business lines that they traditionally dominated, allowing asset managers such as hedge fund managers to step in and fill the gap.

Gerber: Whereas traditionally most of the focus on hedge funds came from large institutions, we have seen an increase in interest in the retail and small institutional segments of the market. A separate trend is toward investors demanding greater transparency from their hedge fund managers, consistent with investor demands of traditional investment managers. Finally, there is evidence that there has been some pressure on fees in the hedge fund space.

Bourdon: New investment trends that we are seeing a lot of interest in are focused towards traditional banking activities such as private loans, which provide stable returns mainly through income generation as well as low correlation to traditional asset classes. Also, from a governance standpoint, we’re seeing a strong interest in greater transparency. In the future, investors should expect to see a lot more variety and greater focus on downside risk management.

Struthers: The global growth of institutional money into the hedge funds has led to a trend of improved transparency, lower fees and increased operational rigour. These are strong positives. Institutions have a much stronger view of how they fit in a portfolio as a risk diversifier, as well as what is required to construct an effective portfolio of hedge funds. There are variants of hedge funds, such as hedge fund replication, which have yet to be proven.

How has institutional money changed the hedge fund space, for better or for worse?

Baram: The changes to the industry are notable. Institutional investors have changed the way they invest. They have also increased their requirements in the areas of fund governance, risk management process, enhanced transparency and legal terms. For example, they require a clear separation of tasks between portfolio and risk management. Some also require the hedge fund manager to amend its general offering documentation to reflect these enhancements and have other clients benefit from it.

In terms of fees, they are certainly pressuring managers to move away from the traditional 2-20. We are seeing a lot of variations on fee structure which we didn’t see before. Overall, the increasing needs of institutional investors have pushed hedge fund managers to make their processes more robust and scalable in order to attract these large allocators.

Gerber: Institutional investors have brought higher scrutiny to the hedge fund industry and a more disciplined approach towards manager evaluation and oversight. To accomplish this, institutional investors have demanded greater transparency from hedge funds. I believe these are positive developments for the industry.

Bisch: Institutional assets have changed the hedge fund space, and Mercer would argue, on balance, for the better. Today, institutional quality due diligence, governance practices, back-office operations, risk reporting, client support, and independent third-party oversight have generally become the standard, which Mercer believes has improved the overall health of the industry.

On the other hand, the institutionalization of the industry has arguably had some negative influences as well. Primarily, institutional flows tend to require scale and demand constrained risk taking. This has resulted in the (already) large managers having bloated assets under management and a more constrained risk/return profile for the industry as a whole. In Mercer’s experience, however, there remains a healthy subset of managers that have seized upon the benefits of this institutionalization without suffering from the above cited drawbacks.

What are the challenges/risks for smaller plans who want to invest in this space?

Gerber: Smaller plans face the same challenges all plans face, but have a few additional ones. The manager selection and oversight process for hedge funds requires time and expertise that is not always resident in small plan sponsors. As a result, smaller plans need to find external resources that can assist with this challenge. In addition, small plan sponsors may not have access to the larger hedge fund managers as a result of minimum investment thresholds. This may force smaller plans to invest in smaller hedge funds or through funds of hedge funds.

Baram: The challenges smaller pension plans face are mainly related to the size of their investments and internal team size. While the typical allocation of these plans is of a decent size (generally $25 million to $35 million), it does not always allow them to negotiate favourable terms with hedge funds managers, to customize the mandate to better suit their needs or to access well-known hedge funds managers (usually requesting larger tickets).

In addition, having smaller internal teams is a hurdle to maintaining coverage of multiple investments and being able to aggregate the information made available to them, such as exposure and risk parameters, which facilitates more informed investment decisions.

Additionally, with a traditional investment into the manager’s flagship fund or via funds of hedge funds, as opposed to segregated accounts or managed accounts, the investor is exposed to a higher level of operational risk which is inherent in the hedge fund manager’s processes.

A managed account platform can help alleviate some of these risks through risk monitoring and risk management as well as tailored reporting while offering the possibility to pool investments from different investors.

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