Fund flows are shifting toward a hedge fund strategy that has been broadly out of favor, and perhaps to firms with fewer assets under management. Should sovereign wealth funds stay the course?
Capital flows into different hedge fund strategies move up and down like hemlines, falling in and out of fashion. Now it looks like the industry is experiencing what may turn out to be another major shift.
In the first quarter of 2015, net asset flows into the broad strategy known as long-short equity have soared, capturing $9.6 billion, well over half the total capital inflows for the period. The spike is striking since long-short hedge funds — so-called equity hedge in industry argot — have been attracting fewer assets since 2008, during the financial crisis, when they badly underperformed the average hedge fund, losing 26.7 percent, according to Hedge Fund Research (HFR), the Chicago data firm.
The shift in flows likely signals rising wariness about stock prices on the part of investors. “As a result of strong gains in U.S. equities over the past three years, investors are increasing allocations to equity hedge in 2015 as a means to obtain alternative beta exposure,” says HFR president Ken Heinz. “Institutional investors are challenged by the current market conditions, specifically the tension between the perception that U.S. equities are already priced to perfection and the risk that the U.S. economic recovery accelerates.”
Since 2008, long-short funds have beaten industry average in most years. But their returns have consistently trailed those of the Standard & Poor’s 500 Index. This underperformance has put off investors since long-short funds are heavily focused on stocks, unlike other types of hedge funds that often invest in a broad range of asset classes, including bonds, currencies, and commodities. Institutional investors are now weighing the risks of high U.S. stock valuations based on any number of metrics such as trailing price to earnings, dividend yields, and total market capitalization to gross domestic product.
There was even a warning last Wednesday from Federal Reserve chairwoman Janet Yellen. “I would highlight that equity-market valuations at this point generally are quite high,” she told a public forum. “Not so high when you compare the returns on equities to the returns on safe assets like bonds, but there are potential dangers there.” So shifting money from long-only portfolios seems the increasingly prudent course of action for many.
Bridgewater and Citadel
The fact is, most of the decisions to pivot toward long-short funds — which include market-neutral, multi-sector, and sector strategies like technology and energy — were undoubtedly made by institutions in 2014. “There is a huge time lag between when they invest and when they make the decision,” says Hossein Kazemi, senior advisor at the Chartered Alternative Investment Analyst (CAIA) Association, an Amherst, Massachusetts, nonprofit education group.
That’s particularly the case with sovereign wealth funds, many of which are substantial investors in hedge funds. “Sovereign wealth funds you’d think would have longer lag times,” says Kazemi. That’s because of their governance structures and committee orientation. State-owned investors often steer clear of pooled vehicles too. “Sovereign wealth funds like to set up separate accounts,” he points out. Those, by their nature, take longer to put in place.
Shifts in investor preference for different categories are par for the course. Macro strategies, which wager on economic trends with sovereign bonds, currencies, futures and other derivatives, had a spate of popularity in the years following the crisis. More recently, event-driven funds, which include those that bet on takeovers or other corporate events, came into fashion from 2013. And relative-value funds, which include convertible arbitrage and other fixed income strategies, have been fairly consistent magnets for asset flows. They were white-hot last year, though, pulling in nearly 60 percent of assets.
Pursuing recent gains, a common phenomenon, is unlikely to be a factor in investors’ recent shift toward long-short funds. For starters, they haven’t outperformed. In 2014, the long-short category returned 1.8 percent compared to 3.0 percent for the average hedge fund and 13.7 for the S&P 500 Index. In 2013 long-shorts returned 14.4 percent versus 9.1 percent for the average hedge fund and 32.4 percent for S&P 500. And in 2012 they returned 7.4 percent versus 6.4 percent for the average hedge fund and 16.0 percent for the S&P 500. Sovereign wealth funds aren’t typically hunting the latest fad. “I’d guess that they are less performance chasers,” sats Kazemi. “They probably go with the safest names, like Bridgewater [Associates] or Citadel.” And they tend to stick around.
Funds of Funds
HFR’s Heinz agrees. “Sovereign wealth funds are generally some of the most sophisticated and deliberate hedge fund investors, taking a long-term position toward their allocations, thoroughly and extensively researching each allocation and remaining extremely patient,” he says. “These primarily allocate to large and mid-sized funds in their efforts to achieve performance targets, and these typically anticipate and position for trends, rather than reacting to them.”
Long-short funds at the end of the first quarter managed $820.3 billion in assets, event-driven funds $775.1 billion, macro funds $568 billion, and relative value funds $775.9 billion. Total hedge fund assets were $2.9 trillion at the end of the quarter, according to HFR.
One factor fueling the growth of long-short funds is the leaching of assets from fund of funds, says Kasemi. Investors have been consistently withdrawing cash from funds of funds, which create portfolios of hedge funds and consequently charge an extra layer of fees, since the financial crisis, including the last quarter. “People are not happy with funds of funds,” says Kazemi. Instead much of that money is flowing into more nimble multi-strategy funds, which is included in the long-short category and which serve much the same purpose with lower fees.
Hedge funds represent a rather small quiver in many sovereign wealth funds’ arsenals, on average. According to Deutsche Bank’s Thirteenth Alternative Asset Investment Survey, they account for just 4 percent of total sovereign wealth fund assets. However, because of the state-owned investors’ enormous scale, their hedge fund portfolios amount to bigger absolute amounts than that of any other institutional investor class, $9.5 billion, according to the survey.
While asset flows continue to favor firms with more than $5 billion under management, that phenomenon may just be starting to ease somewhat. Last year, fund flows into these firms accounted for nearly 51 percent of the total, versus 36.1 percent for those firms with assets of between $1 billion and $5 billion. In 2013, the largest managers gathered 62.6 percent of the total assets versus 26.0 percent for those with $1 to $5 billion. And in 2012 those firms with $5 billion or less experienced net outflows, on average, while the over $5 billion firms roped in $55.7 billion.
Firms with less than $100 million in assets under management have also experienced a gradual increase of inflows over that time frame. Heinz, while cautioning that one shouldn’t read too much into short-term flow figures based on the asset size of firms, says he sees it as a healthy sign of normalization in the hedge fund industry. Institutions may be taking a shine to innovative managers and displaying increased willingness to take on a bit more risk.
Kazemi says some big investors are paying closer attention to asset size — and pulling money out of funds they consider too large. “Maybe some of this is becoming more prevalent,” he says. “There is an optimal size to hedge funds. Some just become asset gatherers.” In other words, size may eventually hinder performance in some cases.
Nevertheless, large firms have consistently outperformed those of their smaller counterparts since the onset of the financial crisis in 2007, according to HFR data. Kazemi says there are size-constraints in certain areas, like some arbitrage strategies, which benefit from staying smaller. That’s something that sovereign wealth funds, with their enormous scale, should consider.