With many investors reporting to Preqin that hedge funds are not meeting their expectations, we take a closer look at the challenges of effective portfolio construction.

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Building a balanced portfolio of hedge funds that meets an investor’s long-term objectives is one of the leading challenges faced by institutions when accessing the hedge fund industry today. With more than 15,000 hedge funds currently open to investment, 42% of investors interviewed by Preqin at the end of 2016 found sourcing attractive hedge fund investment opportunities more difficult than the previous year. In addition to the large and growing number of funds in the marketplace today, significant levels of investors are finding that hedge funds
are not meeting their expectations, which is also contributing to the difficulties investors face when finding funds that meet their risk/reward needs.

In June 2017, Preqin interviewed 178 investors to assess their outlook on the hedge fund industry; the full results are showcased in the newly launched Preqin Investor Outlook: Alternative Assets, H2 2017. In the survey, 55% of investors reported that their hedge fund investments had failed to meet expectations over the past 12 months. With this in mind, we take a closer look at the investment opportunities currently available to institutional investors on a strategy-by-strategy basis to establish the challenges faced by institutions when
accessing the asset class.

Performance Is Driving Investment Decisions

Preqin's survey found that the longer-term performance of the industry is one of the key drivers of decisions made by institutional investors around their hedge fund allocations. Forty-nine percent of respondents plan to reduce their exposure to hedge funds over the next 12 months; the two leading reasons behind this decision were dissatisfaction with the three-year performance of the industry as well as a negative outlook on the performance environment moving forward, with high fees also cited as a concern.

Sourcing Hedge Funds

As well as performance being a driver of redemptions in the industry, the track record of a fund manager is the most important aspect investors consider when initially screening funds. According to a Preqin study of investors in December 2016, 76% of institutional investors look for a successful performance track record in an investment team when initially assessing funds, followed by proven experience in the strategy (54% of respondents).

Investors See Dispersion Of Success Within Their Portfolios

Constructing an effective allocation to hedge funds that meets portfolio objectives is challenging for many investors. As Fig. 1 reveals, beyond the headline figure of investors reporting that hedge funds have failed to meet expectations over the past year (55%), a more nuanced picture emerges. As our June survey shows, 48% reported that over half of their hedge fund portfolios had failed to meet expectations over the 12 months to June 2017. In addition, although 13% of investors have constructed portfolios in which all funds have met their expectations over that period, a similar level (12%) revealed that all of their holdings had failed to meet their benchmarks.

Hedge Funds

A similar theme emerges when we look at this on a strategy basis; investors reported differing levels of satisfaction when comparing hedge fund strategies (Fig. 2). Approximately three-quarters of investors in event driven strategies and credit strategies reported that their investments had met expectations over the 12 months to June 2017; in comparison, less than half (48%) of investors in macro strategies were satisfied with returns.

Wide Dispersion Of Returns Across Hedge Fund Industry

With some investors reporting greater success with portfolio construction than others, as well as differing levels of satisfaction on a strategy-by-strategy basis, we take a closer look at what is driving these trends using data taken from Preqin’s Hedge Fund Online. There has been significant growth in the number of funds in the hedge fund industry. At the end of 2012, there were approximately 12,500 funds within the hedge fund universe; today, this number stands at 14,779. Furthermore, on a strategy-by-strategy basis, there are a large number of options for investors to sort through in order to find the right investment for them (Fig. 3). This can certainly be a challenge, particularly when proven performance success, especially over longer timeframes, is such an important part of the decision-making process for many institutions.

Hedge Funds

When looking at the dispersion of annualized hedge fund returns on a three-year basis, we see across most strategies a significant difference in the interquartile ranges of returns (Fig. 5). In addition, when looking at performance on an annual basis from 2014 onwards, we can see that strategies that performed well one year did not necessarily perform as well the next. For instance, event driven strategies – which are among the top performing strategies in 2017 and were the top performing strategy in 2016 – were bottom of the league tables in 2015 and 2014 (Fig. 4). The data therefore suggests that investors face challenges both in terms of finding the funds that meet their performance expectations as well as creating balanced portfolios across strategies to meet long-term objectives.

Hedge Funds

Portfolio Construction Over The Next 12 Months

The objective for many institutional investors when allocating to hedge funds is to construct portfolios that can help them meet their long-term liabilities by reducing risk and optimizing return over long timeframes. Although broader performance concerns are driving significant numbers of investors to consider reducing their total exposure to the asset class in the near future (Fig. 6), this does not mean that investment activity will decline in the next 12 months. Preqin’s Hedge Fund Online currently tracks 375 investors searching for new funds over the course of the year, as well as many more that will be looking to rebalance and shift additional capital towards existing funds within their portfolio.

Hedge Funds

As shown in Fig. 6, investors have a mixed outlook on the industry when you isolate each strategy. Relative value strategies, which have the smallest interquartile range of the leading strategies tracked by Preqin, and have consistently posted returns of more than 4% in recent years in periods when other strategies have struggled, are the most highly sought by investors. A third of all investors in these strategies intend to increase their exposure to hedge funds over the next 12 months and none plan to reduce their exposure. In contrast, investors have more of a mixed outlook for credit strategies – which have a similarly small range between the bottom-and top-quartile funds to relative value strategies. Although they were among the top performing funds in 2016, they have been less consistent in their annual returns (Fig. 4).

Investors continue to show strong interest in macro strategies following a good start to 2017, in which these strategies amassed $14bn in net inflows, second only to CTAs ($18bn). Although these strategies have failed to generate the same level of returns as other hedge funds in recent years, the large number of investors increasing their exposure to macro strategies indicates that investors continue to build defensive exposure into their portfolios in case of a market downturn or correction. Almost a decade on from the Global Financial Crisis, when macro strategies posted returns of nearly 4% compared to wider losses of nearly 20% across all hedge fund strategies, many investors are beefing up their exposure to macro strategies. The challenge will be finding the right funds; over half of investors in these funds reported that their macro strategy had failed to meet expectations over the past 12 months, and macro strategies have the largest interquartile range on a three-year annualized basis. The strategy also has the largest disparity between the top performing fund (which achieved a threeyear annualized return of 54.43%), and the lowest performing fund (-32.57%).

Outlook

Although performance concerns prevail, a deeper look on a strategy and portfolio basis reveals a more nuanced image of the hedge fund industry. The term 'hedge fund' encompasses a universe of more than 15,000 funds pursuing many different strategies, investment styles, instruments and regional themes. Most investors recognize that many funds within their portfolios are meeting expectations, and that certain strategies are meeting their performance objectives as a whole. However, with the proliferation of funds over recent years, investors are finding it difficult to source the better funds, particularly as the disparity between the top and bottom performing funds within a strategy can be significant. Performance – be it over the last three years or expectations for future returns – is certainly driving many of the decisions investors are making, particularly in conjunction with the issue of fees charged for those returns.

Therefore, intelligence that can help investors cut to the funds that meet their needs may be the first step for many institutions to building the hedge fund investment portfolios that will help them meet their liabilities in 2017 and beyond. For fund managers, in an environment where both keeping capital and growing assets is difficult, it is more important than ever to know investors and to understand not only what their plans are for fresh investment, but also how hedge funds can help them face their challenges in the future.

Article by Preqin

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