Put Into Perspective: Why Hedge Funds And Why Now – Revisited

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Put Into Perspective: Why Hedge Funds And Why Now – Revisited by Skenderbeg Alternative Investments

“Markets stop panicking when policy makers start panicking.” – BofA strategist Michael Hartnett

Pension funds to shift hedge fund allocations to low-volatility, low-beta strategies

Defined benefit plan executives in the US, Canada and the UK are likely to shift allocations within their hedge fund portfolios in response to the near-term prospect of rising interest rates, interest rate volatility and higher equity beta, said researchers from J.P. Morgan’s capital introduction division in their monthly prime brokerage report.

Pension fund chief investment officers are „likely to move away from directionally oriented hedge fund strategies and to strategies with lower correlation, less volatility and minimal beta,” said the report, which was released Wednesday.

Specifically, J.P. Morgan analysts predict that within the long/short equity strategy arena, pension fund officials will decrease allocations to directional hedge funds that have higher net long exposures and increase investment in low-beta/market-neutral equity strategies.

In the event-driven hedge fund category, directional/activist equity-focused strategies will see redemptions, while more money is rotated into low-volatility/correlation approaches, the report said.

J.P. Morgan’s report indicates that plan sponsors will hold their positions at current levels in global macro strategies, while increasing investment in both multistrategy and fixed-income relative-value hedge funds.

Pensions & Investments

Public pension plans now major allocators to hedge funds

The decision by the California Public Employee Retirement System (“CalPERS”) to divest its hedge fund program made quite a media splash in 2014, and caused some pundits to predict the imminent decline of hedge funds. On the contrary, alternative investment data specialist Preqin says public pensions have increased their allocations to hedge funds since last year, and despite generally being later to the game than endowments and foundations, public pensions have become “major allocators of capital” to the hedge fund industry, accounting for 16% of all hedge fund investments.

According to Preqin, pension funds have increased their mean allocations to hedge funds from 7.2% in 2010 to 8.8% at present. Pensions differ with endowments, foundations, and other hedge fund investors in terms of their investment preferences, with 90% of pensions citing North America as their favorite market; with only 33% favoring Europe and 32% liking emerging markets. In terms of favorite strategies, pensions like long/short equity, multi-strategy, macro, and event-driven the best; and commodities and distressed strategies the least.

Reporting on this trend, Chief Investment Officer cited the results of a March survey by KPMG, which was in line with Preqin’s findings. “The days of hedge funds simply being an investment tool for high net worth individuals are over,” said Richard Baker, CEO of the Managed Futures Association, as quoted by Chief Investment Officer. “Institutional investors like pension plans, university endowments, and charitable organizations now make up nearly 65% of the industry’s assets.”


Why hedge funds and why now – Revisited

Back on March 26, we featured an article titled Why Hedge Funds and Why Now. The article was written at a time when there were a number of media articles questioning the performance of the hedge fund industry as a whole after the average hedge fund was unable to surpass the returns of the S&P 500 in 2014. We tried to explain how when the market goes straight up, as it did in 2013 and 2014, any strategy that hedges is very likely to lag the overall market.

We even featured the following chart and pointed out how the S&P had been contained by a tight trend channel for those two years with last October being the only time the index moved outside of the channel and how it was the only time during the two-year period that the index got anywhere near its 52-week moving average.

The following is an excerpt from the article that captures the essence of the article and it is also the reason why we wanted to revisit the article.

“When an overall market gauge like the S&P 500 moves up almost 50% in a two-year period and it does so without much volatility or with only one sizable pullback, yes hedge fund strategies are likely to lag behind the overall market. But what happens when the volatility in-creases and the market drops sharply? That is when investors get the benefit of hedge fund strategies.”

Here we are a little over five months later and volatility has increased and the market has dropped pretty sharply. Have investors benefited from hedge fund strategies? According to industry research firm HFR, the average hedge fund lost 2.2% during the month of August com-pared to the loss of over 6% for the S&P and double digit losses for other world indices. Giving us an answer of yes, investors did benefit from hedge fund strategies in August.

One of the other things we did in the article from March was to compare the slope of the bull markets of the late 90s, from 2003-2007 and the one from the bottom in 2009 through March. The slope of the most recent bullish phase was the steepest of the three.

Another excerpt from the article stated:

The point isn’t to scare investors with the valuations and the comparison between the slopes, the point is that the market is likely closer to another bear market than it is another bullish run. No one knows when or why the next bear market will start, but we also never know when an accident is going to happen and yet we still pay our insurance every month.

Why do we pay for car insurance, homeowners insurance and medical insurance? To protect against the downside risk of being in a car accident or having our house catch fire or burglarized. We would all have more disposable income if we didn’t have to pay for insurance each month, but we do it because it gives us peace of mind. Hedge fund strategies can be viewed in the same manner. The performance would be better if they weren’t protecting against a downside move, but then they also wouldn’t be protected from a downside move in the market and they wouldn’t provide the peace of mind that they offer.

Investor sentiment is an amazing thing. The market goes up for six years and investors forget that they go down as well as up. Since the bot-tom of the most recent bearish phase in 2009 through August, there were only six out of 79 months where the S&P saw a monthly loss greater than 5%. During the financial crisis from October 2007 through February 2009, the S&P experienced monthly losses in excess of 5% six times in 17 months.

We have tried to persuade investors to not let their guard down. Look at these articles from the last few months:

– July 20 – Are investors bailing on active strategies too soon?

– June 26 – Wrong time to abandon hedging strategies

– June 19 – Pension funds behaving like individual investors

All of them are emphasizing how markets go up and markets go down and how you have to protect the downside and yet investors, institutional and individual investors alike, seem to get caught up in the up cycles and then forget there are down cycles. They get greedy and want to capture upside, but they don’t want to protect the downside any longer because it is costing them money. When the sentiment hits that level, that is when the market usually turns.


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