By John Anderson, Managing Director, Hedge Fund Solutions, J.P. Morgan Alternative Asset Management
Hedge fund assets have managed to maintain and increase their market share well beyond their pre-2008 financial crisis levels as investors’ demand for their alpha potential and risk-mitigating characteristics intensifies.
This growth persists despite challenging industry performance, regulatory changes and investors’ heightened concern regarding risk, liquidity and fees.
As the industry has matured and developed, these factors have affected all investors, but the greatest impact has been on institutions—whose hedge fund holdings now exceed those of high net worth individuals.1
So, are hedge funds worth the exposure?
While it is true hedge fund returns have not kept up with traditional assets in the current bull market, the asset class should be measured by its contribution to the risk-return profile of the overall investment portfolio, not against traditional benchmarks. Hedge fund portfolios—including equity-focused portfolios—are not 100% long-only, making the comparison to long-only indices inappropriate. For example, for a diversified portfolio with a look-through net equity exposure of 30% or less, it would mean that for every $1.00 invested, only $0.30 would be exposed to equity market (beta) risk. Such portfolios are likely to trail in equity bull markets that are driven by unconventional monetary policy while providing protection in down markets.
Over the past 15 years broadly diversified hedge fund portfolios2 have demonstrated this ability to provide a buffer in down markets with meaningful participation in up markets, when compared to both equity and fixed income.
Hedge funds’ complementary characteristics are also demonstrated when a diversified hedge fund allocation is integrated into a traditional portfolio. For example, over the same 15-year time frame, adding hedge funds to a 60% equity/40% fixed income blended portfolio increased returns and decreased volatility.
This said, a major concern for clients continues to be what implications regulation may have on their allocation to hedge funds. However, changing regulations are having both a negative and positive impact on the hedge fund industry.
On the negative side, some regulations have the potential to restrict certain investment opportunities. For example, prime brokers are becoming more selective in doing business with smaller hedge funds, preferring to engage with larger managers as they tend to be more profitable. This can make new hedge fund launches difficult, possibly constraining the universe of emerging managers.
Innovation from regulation
Other regulatory changes, however, appear to be having a more positive impact. Rules prohibiting proprietary trading, for example, have prompted talented managers to spin out, opening their strategies to outside capital.
Regulation has also contributed to industry innovations that are helping hedge fund solutions providers address specific client needs, such as innovative longer-duration strategies designed to take advantage of illiquidity premiums resulting from the pullback of bank capital. On the other hand, for some liquidity-constrained investors seeking to incorporate the risk-return characteristics of hedge funds into their portfolios strategies such as liquid alternatives may be a partial solution. For large hedge fund managers considering liquid alternative mutual funds as a new way to put their years of expertise to use, SEC registration requirements that are part of the Dodd-Frank Act have lowered the barriers to entry. A similar trend is occurring in Europe where UCITS regulation allows investors to access liquid alternatives in a regulated format across Europe.
An outlook for growth
Although a small, but vocal, number of large investors have exited hedge funds, many more are adding to existing allocations or creating new ones. According to our 2015 Institutional Investor Survey conducted by J.P. Morgan’s Capital Introduction Group, 94% of institutional investors plan to maintain or increase hedge fund exposure in 2015. This has been reflected in both the strong flows which have driven industry assets to an all-time high of $2.8 trillion3 and several large hedge fund commitments recently announced by state pension plans.
1 The 2014 Preqin Global Hedge Fund Report (December 2014)
2 Represented by the HFRI Fund Weighted Composite Index
3 As of December 31, 2014