Sentiment toward hedge funds has been negative in recent years, in large part because industry returns were poor in 2015 and the first half of 2016. Also, CalPERS and other institutions left the asset class, amid a wider debate about active management in general, and hedge funds’ fees, in particular. While some of the criticism was justified, we think it’s not fair to paint the whole industry with a broad brush.

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Furthermore, there are several positive developments underway in the still-young industry, including better alignment of fees between hedge funds and their investors; improving transparency and client service; and ongoing advances in institutional infrastructure.

Finally, market conditions are improving, and some new ways to achieve alpha are developing. Before we explore the last two points, let’s review hedge funds’ potential benefits and the role they can play in the portfolio of an institution or a qualified private investor.

The case for hedge funds

Hedge funds provide their investment managers with strong incentives to generate performance for clients by charging performance-related fees. In most cases, managers invest a large portion of their liquid net worth alongside their clients, which gives them additional motivation to perform well.

Hedge-fund managers typically have flexible and broadly unconstrained mandates. They can often invest across a wide range of assets classes, geographies and instruments, including both listed and unlisted cash securities and derivatives. As the business and investment cycles turn, hedge-fund managers can move capital to new opportunities or reduce risk in the face of increased adversity. Traditional investment managers often do not have the same flexibility. While unconstrained mandates can be subject to style drift, we think the potential benefits outweigh that risk.

Finally, hedge funds have historically provided attractive returns with relatively low correlations to traditional asset classes, in large part because their incentive structures and flexibility have attracted many highly talented investment professionals.

Of course, hedge funds aren’t for everyone: They are only for qualified investors, and generally, they should comprise only a limited part of one’s overall net worth. Fees for hedge funds are usually higher than for long-only portfolios, and the risks differ, as well. Each hedge fund entails unique risks; careful due diligence is required.

Improving market conditions

Despite recent controversies and a few high-profile investor exits from the asset class, global assets under management for the hedge-fund industry are at an all-time high of $3.1 trillion, and performance is improving for many funds. Many institutions are now adding to their allocations, because stretched valuations have reduced expected returns for traditional asset classes. We believe that investors who invest in a well-diversified portfolio of best-in-class managers can garner attractive returns that diversify their traditional asset allocations.

It’s true that both hedge funds and traditional active managers have struggled to excel in recent years. Our research suggests that’s because massive central bank stimulus, slow economic growth, and compressed risk premiums have narrowed the dispersion of returns both within asset classes and across asset classes and countries. While we don’t expect interest rates to rise rapidly, we think that the central bank easing underway in the US and expected abroad will lead to more appropriate pricing of risk.

What does that mean? We believe that over the next few years, it will matter more which companies’ stocks or credit you own, and which ones you take short positions in on expectations that they will underperform. We expect investors to evaluate countries once again based on their policies and economic outlook, and price their currencies, bonds, and stock markets accordingly. All this should provide greater opportunities for hedge funds and other active managers to exploit.

A recent survey conducted by Bank of America Merrill Lynch shows increased interest in many hedge funds’ strategies. While demand is falling for macro funds, managed futures, and commodity/currency strategies, demand is rising for other types of strategies, most notably equity long/short, equity market neutral, event-driven, and distressed securities, as the Display shows.

Hedge Funds

New implementations

Another important change underway is the advent of rule-based, systematic ways to pursue certain types of return sources, such as merger arbitrage. In this strategy, funds seek to profit from a takeover by buying stock in one company involved in a deal (usually the target) on expectations that it will rise, while selling short the shares of the other company (usually the acquirer) on expectations that its stock will drop. Until recently, most investors had to invest with a hedge-fund manager with perceived skill in selecting the right deals, with the hope that the alpha generated would exceed the fees. Today, it’s possible to invest in a passive approach that takes both long and short positions in each takeover underway. We’ve seen this approach generate attractive returns at a very low cost.

In sum, we’re optimistic. We see market conditions improving for the hedge-fund industry and increased diversity in the strategies and styles that hedge funds deploy. In some cases, lower-cost implementations can also improve net returns.

The views expressed herein do not constitute research, investment advice, or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

Article by Stuart Davies, Vikas Kapoor - Alliance Bernstein