The challenging market conditions of 2018 show few signs of improvement as we enter 2019. Faced with the resurgence of market volatility, the flattening of the yield curve and a geopolitical climate that would only a few years ago have sounded improbable, alternative assets managers will have many obstacles to overcome in the next 12 months. However, with indications of an imminent market correction, the ability of hedge funds to protect investors in the event of a downturn may never be more important.
Maturing investor portfolios
Post-GFC, the value of hedge funds to investors was clear; institutional investors, particularly those in Europe and North America, faced with the proposition of failing to meet long-term liabilities and needing diversification and a source of risk mitigation within portfolios, turned to hedge funds. However, in recent years, the rush to build portfolios of hedge funds has slowed as investor portfolios matured, with many investors reaching their preferred exposure to the asset class, and we have noted signs of a deceleration in industry assets under management (AUM) growth.
Despite this, today at Preqin we track more institutional investors than ever, collectively allocating record sums of capital to hedge funds. With this in mind, in the event of a new market crisis, the defensive value that hedge funds proved a decade ago during the GFC will be vital to protecting the capital of thousands of institutions and, ultimately, the millions of pensioners and students and the wider populace, on behalf of which these pension funds, endowment plans, sovereign wealth funds and others are investing.
Beyond just absolute returns
The question of performance has been central to the success and failure of participants in the hedge fund sector over the past decade. Following the first double-digit annual return in five years in 2017 (+11.99%), 2018 was certainly a disappointing year for hedge funds. Collectively, hedge funds lost 3.41% in 2018, the worst annual return for the Preqin All-Strategies Hedge Fund benchmark in almost a decade. It is hard to deny that relative performance over the past five years has been a point of contention for many institutions. With public markets enjoying an extended bull run, hedge funds, which typically charge higher fees for a seemingly a smaller return, proved a hard pill to swallow for some investors. As a result, we saw some investors strip back their hedge fund exposure or exit completely in recent years.
However, in 2019, the performance question is moving away from historical comparisons with public markets and towards the forward-looking role that hedge funds will play in difficult market conditions, especially given the losses of many public markets in 2018. Investors are reaching a consensus that we are at the peak of the equity market, and with concerns that a correction is imminent, many investors are looking to position their hedge fund portfolios more defensively as a result. So, in fact, despite the majority (55%) of surveyed investors reporting disappointment with the 2018 return of hedge funds, the defensive properties a hedged portfolio can offer in 2019 are leading to signs that investors are weighting back into hedge funds. For instance, we have noted that the largest proportion (79%) of surveyed investors plan to maintain or increase their exposure to hedge funds in the next 12 months since 2014. In addition, for the first time in four years, we have recorded a greater proportion of investors looking to increase their exposure (29%) over the longer term than decrease their exposure (12%).
With investors indicating they are positioning more defensively in 2019, those funds with a large long exposure to equity markets may see outflows, as investors look to strategies less correlated to market beta – macro strategies, CTAs and relative value strategies for instance. Not even the largest funds will be safe from investor withdrawals: we expect investors to continue to evaluate all managers in light of their performance, costs and ability to navigate difficult markets, regardless of size, in 2019.
A positive outlook in difficult Times
Despite industry assets falling in the second half of 2018, as a result of the combination of investor withdrawals and performance losses in Q4 2018, there are signs that 2019 may be a more positive year. Firstly, although we do not expect the established investors in Europe and North America to invest fresh sums of capital in the volume we saw a decade ago, we are seeing high levels of activity in terms of reallocating capital as investors tactically rebalance portfolios. Alongside this, investors in emerging markets – Asia in particular – continue to dedicate larger and larger sums to hedge funds, replacing some capital that may have been pulled out from institutions in the US or Western Europe. So, while on the surface, the slowdown in flows and AUM growth may indicate a lack of activity, beneath the surface there is much activity as investors rebalance towards defensive strategies and investors in the East ramp up their portfolios. If investors’ fears of a market correction prove true, 2019 will certainly be a time for hedge funds to prove their worth.
For expert commentary, key trends, historical statistics and survey results, take a look at the newly-released 2019 Preqin Global Hedge Fund Report – the most complete and in-depth review of the industry available.