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The niche factor
The niche factor
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The niche factor

16/09/2016

Andrew Dougherty

Andrew Dougherty

Managing Director, Head of Alternative & Institutional Solutions

BNP Paribas Securities Services

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Andrew Dougherty of BNP Paribas looks at emerging hedge funds' uncanny ability to outperform their larger peers

Despite besting their S&P counterparts, the meager 2.02% return notched by US hedge funds during 2015 was certainly nothing to crow about. Last year’s underperformance continued a five-year dry spell that saw hedge-fund yields rise just 1.7% on an annual basis, or roughly 9% lower than the major indices through the period.

As the industry continues to expand, scale has gradually become synonymous with success: today the vast majority of AuM is controlled by a mere 12% of hedge funds, according to alternative industry research group Preqin. Those who only flock to the largest funds, however, may be missing out on one of the industry’s best-kept secrets: smaller, start-up or “emerging” hedge funds that, despite having significantly lower AuM and only a few years’ experience to their credit, nonetheless have demonstrated an uncanny ability to outperform their larger peers.

A Changed Paradigm

Historically, hedge funds have served as a non-correlative strategy intended to help offset losses in traditional investments during down markets, while holding steady or posting moderate gains through up cycles. No longer the exclusive club it once was, today’s hedge-fund membership includes the likes of large public and private pension plans, insurance firms and other mainstream entities. Along the way hedge-fund AuM has soared, rising from just $257bn in 1996 to an estimated $3trn today, according to Hedge Fund Research (HFR).

The growth in institutional participation has led to a significantly larger and more competitive environment for hedge funds, making alpha generation more labour intensive in the process; it has also placed increased emphasis on funds’ due-diligence practices, which itself has weighed on returns due to the added cost of implementing more robust risk-management solutions. And as the industry continues to expand, non-correlation has been harder to come by—larger funds in particular have been more likely to move with the broader market.

In a market where the biggest winners often have the slimmest margins, the elevated “2 and 20” historical fee structures of hedge funds—whereby investors pay a 2% AuM charge and 20% of total annual gains—have become an increasingly thorny issue, particularly in light of hedge funds’ recent sub-par performance. This has led many clients to seek lower-cost opportunities elsewhere including ETFs, liquid alternatives, as well as index mutual funds and other passive strategies. According to HFR, hedge-fund redemptions exceeded $15bn during the first quarter of 2016.

Still Attractive

This is not to say that hedge fund investors haven’t been well served over the long haul. Since 1990, the industry has returned 10% annually (as measured by the HFRI Index). Much of that gain came during the go-go 90s, however, during which time hedge funds yielded an annualised 18.3% (compared to just 3.4% yearly since 2006).

Nevertheless, with stock multiples getting pricier and interest rates once again heading lower, hedge funds continue to represent an attractive—in some instances, necessary—opportunity for institutional asset managers. Globally, alternative strategies have been integral to pension-plan alpha generation, and with rates not expected to budge for some time, managers will likely continue to rotate into hedge funds and other alternatives.

A slew of new data appears to support this. According to Preqin’s annual Global Hedge Fund Report, combined hedge-fund AuM approached $3.2tn through the end of last year, fueled by $71.5bn in new capital inflows. And in its own Global Hedge Fund Distribution Survey, PriceWaterhouse Coopers, in conjunction with the AIMA, found that some 44% of global hedge fund managers anticipate introducing a new fund product by the end of 2016, while more than 6 in 10 noted an increase in hedge-fund AuM.

Despite the loss of heavy hitters such as the California Public Employees Retirement System (Calpers) and New York City’s pension fund (Nycers), the number of institutions with hedge fund allocations currently stands at around 5,000, according to Preqin. And with good reason: from 2008-2014 pension plans suffered a 9% drop in funded status, according to data from Moody’s, as liabilities increased by 69.5% while assets grew by just 42.5% through the period. With the number of retiring baby boomers on the rise, pressure on pensions to maintain sufficient funding will almost certainly persist, reports Moody’s.

 

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