Institutional investors allocating towards Hedge Funds have very different performance expectations as do the same investors allocating to private equity. In Preqin’s first half investor outlook for alternative investments, the institutional investors surveyed expressed increasing dissatisfaction with hedge funds while private equity and a move towards absolute return investments were shining.
Hedge funds receiving lowered future allocations, Preqin report indicates
When 460 institutional investors were asked in a global survey to reveal their thoughts on investment logic behindalternatives, respondents ranging from pension funds, foundations, family offices, endowments and many others gave generally bad grades to hedge funds where private equity and private debt and infrastructure investments found favor.
Considering their plans for allocations on a longer term time horizon, 51 percent of investors plan to extend private equity exposure, while 44 and 38 percent want to increase allocation towards private debt and infrastructure respectively. Conversely, hedge funds see the highest level of those allocators who plan on reducing exposure to this investment category and the lowest level of those who plan to increase allocation.
The dissatisfaction can also be seen in institutional investor’s general perception of asset classes. Hedge funds achieved the lowest number of positive rankings, 4 out of 10, and tied for the most number of negative ratings. Why is this? Coming into today’s market activity, hedge funds were generally performing ahead of stocks. While the lead has gone back and forth, for the most part hedge funds have outperformed stocks all year long, a relative rarity as historically the stock market has outperformed the “average” hedge fund. The issue might not be about absolute performance in all cases, but rather marrying performance expectations to an investment strategy.
Look to investor stated objectives, are they being met?
In part the reason for institutional concern for hedge fund investments might be performance expectations. Hedge funds received the highest negative, four out of ten, when investors were asked for their performance expectations. Hedge funds only received one positive rating for performance over the last 12 months, which is odd. After generally underperforming stocks in 2014 – dividend reinvested investment in the S&P 500 netted 13.68 percent while the Barclay Hedge Fund index squeaked out just 2.8 percent positive performance that year – stocks spent most of 2015 underperforming the hedge fund index, particularly near the start of the year.
This underperformance of expectations is also odd given the performance expectations for hedge funds. While the largest percentage of institutional investors are looking for private equity returns near 15 percent, the largest response relative to anticipated hedge fund performance was near 7 percent, or roughly half the performance expectation of the leading alternative investment, private equity.
Perhaps another clue as to negative performance expectations might also be found in the stated objectives for an investment. Private equity, clearly based on investment objective and returns expectation, is looking for absolute performance. Hedge funds, when placed in an institutional portfolio, have a diversification, low correlation and volatility reduction mandate. In fact, looking at the combined chart for performance expectations between hedge funds and private equity, one notices what appears almost like negatively correlated distribution. Indeed the expectations for hedge fund performance has very much the look of a fat left tail and expectations for private equity performance have a decided fat right tail.
Are institutional allocators satisfied with returns?
Perhaps the question to ask is: are hedge funds meeting their mandate? The answer depends on several factors, including what hedge fund index is chosen for study measurement, how truly representative that index is relative to the whole and, importantly, how a hedge fund correlates to the performance of the stock market. This could be the issue. While correlation analysis was not provided in the Preqin report, cursory review shows that, on average, hedge funds correlate at nearly 0.7 to 0.8 to stock market benchmarks. When 1 is the top of the scale, that’s a pretty high performance to the stock market. Could institutional investors be upset at hedge funds due to their high correlations to stocks, particularly during crisis? This cannot be determined from the report, but rather the primary consideration in a hedge fund investment – low correlation – is likely to be unmet, which could be cause for consternation among institutional allocators.
In an accompanying editorial piece covering “Satisfaction with Returns,” Preqin notes that return expectations for private equity investments may be due to recent returns experience. The study of expectations “shows that over a third (35%) of respondents stated that their private equity fund investments had exceeded their expectations in the last year, which is a substantial increase on previous years.” This could be, to an extent, indicative of a trend to various degrees. “In recent times, the proportion of investors that had their expectations surpassed for their private equity portfolios has been declining,” the report noted.
View the full report here.
This article was originally published by ValueWalk.
Photo: Garry Knight