Towers Watson says institutions will stick to hedge funds despite underperformance

17 Jul, 2012

Investors are unlikely to jump into bed with other asset classes en masse if hedge funds do not deliver absolute returns by year-end 2012, Towers Watson has said.

The industry has posted sluggish returns so far with the HFRI Fund Weighted Composite Index up just 1.87% year-to-date.  This comes off the back of 2011 when hedge funds were down 5% for the year underperforming equities by eight percentage points. Some hedge funds have said privately that 2012 has to be the year they distinguish themselves and outperform industry benchmarks – an ambition that is unlikely to be realised.

Nevertheless, Craig Stevenson, senior investment consultant in the hedge fund research group at Towers Watson, reassured managers that institutions appear to be keeping the faith. “If managers deliver flat returns at the end of 2012, I do not believe it is going to be a watershed moment. The hedge fund industry will not suddenly go away,” he said.

“But some investors might move into other asset classes such as long-only. Alpha is thin on the ground and many investors recognise that. Furthermore, a lot of conservative institutions are satisfied with alternative beta  and content that hedge funds are protecting their capital in these tough markets,” he added.

Hedge funds are managing record AuM, which currently stands at $2.13 trillion, according to Chicago-based data providers Hedge Fund Research. This growth looks set to continue – an April 2012 J.P. Morgan cap intro report said 93% of investors look set to maintain or increase allocations to hedge funds.

Towers Watson’s own research is bullish on hedge funds’ standing. Of the $3 trillion invested in the top 100 alternative investment managers on behalf of institutional investors, $643 billion or 21% of that is in hedge funds ( which are included in the survey for the first time). In terms of AuM hedge funds are behind real estate (35%) and private equity (22%) but ahead of private equity funds of funds, funds of hedge funds, infrastructure and commodities.

The surge is attributable to return-hungry pension funds and investment consultants increasingly embracing hedge funds.  Many of these institutions are not looking for hedge funds to deliver outsized returns but steady, consistent capital preservation, a point reinforced by Goldman Sachs Prime Brokerage survey back in April. According to Goldman’s findings, investment consultants set the lowest return targets of just 6.6%.

Stevenson, however, acknowledged that managers with poor returns were facing substantial pressure on the 2% management and 20% performance fee. The J.P. Morgan survey confirmed this saying 42% of investors negotiated the management fee while 26% reduced the performance fee. However, he cautioned investors against being too aggressive with fees, particularly on smaller managers when they suffer a down month or two.

“Fees have been under pressure for a while now. A lot of managers with modest AuM of around $100 million need all the fees they can get to ensure their operations are solid. Putting pressure on these managers during a spell of poor performance is counterintuitive and can actually harm the manager and end investor,” said Stevenson.


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