Low interest rates and unfunded pension fund liabilities are encouraging institutional investors to re-think their allocations to traditional assets like equities and bonds, and seek alternative sources of income and growth. BlackRock analysis of the industry found the average (median) hedge fund generated alpha of 3.1 per cent against an index return of 9.1 per cent (HFRI Fund Weighted Composite Index) in 2013.
Mark Woolley, Head of European and Asian Hedge Fund Research at BlackRock Alternative Advisors,says: “Hedge funds often get compared to standard equities benchmarks, but institutional investors don’t look at them this way. Of course gross returns matter, but large institutional investors are much more interested in the risk and return characteristics of their portfolios and many will have been very pleased with the alpha their hedge fund managers delivered last year.” BlackRock’s research examined the 2013 returns of 1,563 hedge fund managers in the Hedge Fund Research, Inc database, separating returns into three categories – ‘traditional beta’ such as general market returns, ‘non-traditional beta’ such as equity sector spreads, and ‘alpha’ – the component of the returns that was unexplained and therefore attributable to manager skill. While the average (median) hedge fund delivered 3.1 per cent of alpha, different strategies and styles provided differing opportunities.
2013 was a particularly good year for investors in event-driven hedge funds, which seek to profit from market events like mergers and acquisitions or short sales of distressed securities. On average, median alpha in this group was 4.8 per cent against an index return of 12.6 per cent (HFRI Event-Driven Total Index). Woolley says: “Institutional investors want diversifying assets to smooth overall portfolio returns and minimize funding level volatility, and many strategies would have helped them achieve this. However, the dispersion of returns between the best and worst performers is wide, so picking the right managers in a systematic way is key.” Because of market challenges many pension funds, insurers and other institutional investors are considering increasing allocations to hedge funds and other alternative investments in 2014.
In December, BlackRock surveyed 87 of the world’s largest institutional investors representing over USD6 trillion of assets. 28 per cent of respondents said they intended to increase allocations to hedge funds in 2014 while just 13 per cent said they would decrease allocations – a net 15 per cent increase. Woolley says: “The role that hedge funds play in institutional investor portfolios is changing. For many years, people saw them as homogenous, high risk and high return investments comparable with risky asset classes like equities, but this view has changed and many institutional investors are using hedge funds as sources of differentiated risk exposure and returns that are uncorrelated to traditional markets. Today, we see good opportunities in direct lending, arbitrage strategies, long/short equities and distressed debt.”