• Diversification: For 72% of investors, diversification to other asset classes remains the main benefit of investing in hedge funds. This means investors will be sticking with the asset class (see Fig.1).
Diversification is the most attractive aspect of hedge fund investing by a considerable distance as shown by the graph above. We see these results as very promising signs for the hedge fund industry. Firstly, whilst the correlation across all asset classes increased significantly at the height of the crisis in 2008, the Hedge Fund Research Index (HFRI) outperformed both the S&P 500 and the MSCI World for 2008. So, whilst many hedge funds collectively ended the year in negative territory, the losses were on average far less severe than those of other asset classes.
This has been particularly well recognised by investors who have both long only and hedge fund portfolios.
Secondly, the small but significant number of hedge funds that generated returns anywhere between 5% and 50% last year demonstrates that it is possible for hedge funds to generate absolute returns even in the most severe market conditions.
Lower volatility than other asset classes and a better sharpe ratio are also important to investors, but to a lesser extent. Almost 40% of investors chose these two aspects as two of the main benefits of hedge funds, whilst only 1.5% responded saying that higher volatility than other asset classes was beneficial; considering the events of 2008, amid record levels of volatility, this is hardly surprising.
• Cash levels remain high: Respondents are sitting on $294bn of cash. In 6 months time they expect to have reduced this to approx. $212bn. This
perhaps suggests that $82bn of cash will be re-invested over the next 6 months.
The reasons for redemptions have been well documented. Clearly, performance has been a driver, but client pressures have compounded the withdrawals. Investors, under pressure from their own investors, have been forced to redeem from even the best performing managers. Investors have therefore been raising cash to meet these redemptions (which, in many cases, were on a smaller scale than anticipated) as well as to be able to move opportunistically going forward. In some cases, investors have been confused by market behaviour, and in 2009 cash has been seen as the only safe “asset class”.
Nearly 50% of investors are currently holding between 5 and 30% cash, a significant holding and an increase from last year’s survey. It is interesting to note there was a high percentage of respondents for which this question was not relevant or that preferred not to answer – perhaps indicating the concerns about disclosing high cash levels, while still charging fees.
We also asked investors what their average cash position was during the first 6 months of 2008, when an overwhelming 50% of investors responded that they were holding 10% cash. Only 11% were holding 20-30%; 35% still refused to disclose. However, by the second half of 2008, that 50% that were holding 10% cash had reduced to 34%, with those investors holding between 20-30% and 30-40% increasing to 18% and 8% respectively. These changes reflect the deteriorating market outlook, then as investors moved to raise their cash levels and expected cash levels to continue to remain high.
However, while levels are expected to remain high relative to cash levels seen prior to this crisis, investors expect to redeploy a substantial percentage by the end of the first half 2009. Respondents are currently sitting on $294bn of cash. Should things remain stable, in 6 months’ time, they expect to have reduced this to approximately $212bn, suggesting that $82bn of cash will be perhaps invested back into the industry over the next 6 months.
• 66% of investors expect there to be outflows in 2009 of $168bn taking the industry to $1.33trillion (see Fig.2)
Despite the compelling evidence that suggests investors will be putting cash back into hedge funds over the next 6 months, it is clear that the majority still expect the industry to experience net outflows for 2009 (67% overall). This is clearly bad news for the industry, but it is certainly not unexpected. Furthermore, a positive quarter for both investors and managers and this trend could easily be reversed.
Nevertheless, the landscape is changing
• Investors, like hedge funds, have de-levered: 72% of investors have reduced their exposure to leverage and 63% are not interested in applying leverage to their own portfolios this year (see Fig.3 & Fig.4).
There has been a clear change in investors’ approach to leverage since the beginning of 2008. In last year’s survey, over 24% of investors said that they used leverage, and a further 12% implied that they were interested in doing so. However, these figures have fallen significantly in the space of 12 months, to 12% and 4% respectively.
The significant reduction of leverage has of course also contributed to the smaller size of the industry as a whole. Leverage, that had historically been an attractive means of achieving outsized returns for many funds and investors alike, proved to be the downfall of many, as market volatility and magnified losses took their toll. As a result, much like the funds in which they invest, investors dramatically reduced leverage on their own portfolios. However, leverage is a function of manager confidence. If market stability returns it would be logical to expect hedge funds to re-lever.
• Continued consolidation and a premier league of hedge funds are emerging: 50% of our respondents invest in hedge funds with an average AUM of between $800mn - $4bn ensuring the larger funds continue to grow and, hopefully, thrive.
As a result of the current financial crisis, as well as calls for more intense scrutiny of hedge funds from politicians and regulators alike, we expect the industry to change in such a way that leaves fewer funds, with higher quality managers, and more effective rules regarding transparency and risk management.
Size is becoming increasingly important for two main reasons: firstly, higher quality managers with strong track-records will naturally attract more investors and larger tickets. Secondly, as the banks continue to deleverage and shrink their balance sheets, smaller accounts, which generate less income for their prime brokers, will be the first to suffer.
There is a marked reluctance on the part of investors compared to previous years to allocate to managers with a small AUM, as shown in the graph above.
Clearly substantial consolidation is expected within the industry this year and we anticipate that investors will be particularly keen to ensure that any new allocations made are to managers who will survive the current crisis.
Recent events have made investors more attentive
Historically, investors have indicated the “3Ps”: Performance, Philosophy and Pedigree to be the most important characteristics when selecting a manager.
However this year, Risk Management has displaced Philosophy as the second most important criteria and Transparency is now fourth, pushing Manager Pedigree to fifth place.
• Risk Management moves to being the second most important factor when selecting a manager.
78% of investors specified risk management as the second most important factor when selecting a manager. Risk management has been gaining on the “3Ps” since 2005 and in 2008 replaced manager pedigree. This year it displaced manager pedigree and philosophy.
In the post-Madoff era, this concentration on risk management is an expected development. Furthermore, with the continued institutionalization of the industry, investors have become more risk aware, needing to meet higher institutional standards with regard to their risk management processes.
• Transparency joins the top 5 manager selection criteria.
The focus on transparency was also borne out when we asked investors what their biggest challenges when it comes to investing. In a year where almost every aspect of investing raised its own set of problems, lack of transparency came in third place, behind selecting/monitoring managers and poor returns. It was perceived to be even more of a problem than redemptions from their own investors – the headline item of the year.
• Increased appetite for managed accounts: 43% of investors are now considering making a proportion of their investments through managed accounts which offer considerable transparency, liquidity and reporting benefits.
As the liquidity crisis intensified and investors focused increasingly on transparency and risk management, managed accounts seem to have become more attractive to a large percentage of the investors surveyed. 43% of investors said they would be more likely to make a proportion of their investments through managed accounts in the future. With 9% of investors already using managed accounts, (according to our survey last year) a significant portion of the universe is now considering moving to this form of investment.
This trend to a more liquid and transparent form of investment has been increasing steadily since we started asking investors about managed accounts in 2004 (only 20%). In addition, it is not just investor sentiment that impacts the increased interest. As raising capital becomes ever more challenging, managers that may previously not have considered running a separate account are recognizing the benefits of this structure in terms of attracting new, and retaining existing, pools of capital.
Investment intentions
• Strategy preferences and predicted best performers in 2009: Macro, CTA, L/S. Investors overwhelmingly predict global macro to be the best performing strategy, followed by CTAs and Equity L/S, perhaps pointing to the attraction of liquidity. However, these strategies were rivaled by Distressed and Credit L/S, among the least liquid.
Global macro was one of the few strategies to earn positive returns in 2008, and it is now being rewarded for it. The proportion of investors planning to add allocations to this space has more than doubled from 21% last year to 47% in 2009. 60% of insurance companies who responded to the survey are planning to increase their global macro allocations.
CTAs were the best performing strategy last year outside of short-biased funds. As a result, the proportion of investors adding allocations to this space has remained high, growing slightly from 28% last year to 31% this year. Part of the continued demand for this strategy is arguably as a result of CTAs good liquidity relative to other strategies at a time when the ability to make quick redemptions has skyrocketed in importance. Over 40% of both banks and investment consultants are planning to add allocations to this space.
Equity long/short remains in roughly the same position as last year, with 30% planning to allocate to the space. Notably fewer investors are planning to reduce their positions this than last year. More than a third of family offices, fund of funds, insurance companies, and wealth management companies are planning to allocate to the space.
While down from 37% planning allocations in our 2008 survey, credit long/short remains a popular strategy going forward into 2009 with over 30% of respondents planning to allocate. The strategy is particularly popular with wealth management companies and investment consultants, with over 25% of each group planning to allocate to this strategy.
The distressed space has by far the largest proportion of investors planning to add allocations this year. This is unsurprising given the record declines in nearly every asset class in 2008. However, many investors have been burned by bad performance in the space in 2008. The fact that investors are planning to add versus reduce allocation by a four to one margin could be seen as a broadly bullish take on the market overall. Nearly half of all banks, foundations, and wealth management companies are planning to allocate to this strategy.
• USA is predicted to be best performing region. 46% of investors think that the USA will be best performing region in 2009. Eastern and Central Europe and Russia are predicted to perform the worst by 41% of investors.
The majority of investors predict that the best performing regions for hedge fund investments in 2009 will be the United States and Canada. The percentage of investors that predict this has doubled since last year, from 23% to 46%.
One of the most significant contrasts to our 2008 survey, however, is the emphasis on China as a region that is expected to perform well in 2009. In last year’s survey, only 10% of investors felt that China would be the best-performing region of 2008; for 2009, however, that figure has risen to over 28%.
41% of our respondents predict that Eastern and Central Europe (including Russia) will be the worst performing region for hedge fund investments in 2009 (up from just 17% last year). This is perhaps surprising given that the MSCI Emerging Europe finished down -68.36% for 2008; how much further can it fall.
• Despite the fact that 71% of respondents think the markets (MSCI World) will be down 0-<-20% this year, 92% think their own hedge fund portfolios will deliver positive performance. 40% even think they will conclude 2009 with +5 – 10% performance.
But there are still caveats
• Net outflows expected from the industry in 2009. Over 75% of investors expect there to be net outflows from the industry and 30% think these outflows will be over $200bn.
• Redemptions are still the biggest challenge facing managers in the next 12 months. The question of survivability is likely to be a key in influencing investors’ allocations this year, particularly given the number of managers expected to close in 2009. Investors overwhelmingly indicated that they felt the continued pressure over redemptions would be the greatest challenge for managers in 2009.
The top 3 challenges highlighted when our respondents were asked what the top challenges were managers faces in the next 12 months were:
(1) Redemptions: 82%
(2) Illiquid markets: 70%
(3) Performance: 50%
Many managers and investors are still experiencing redemptions. Although these have slowed down since 2008, managers and investors are still suffering. This is reflected by our responders, who predict outflows in 2009 of $168bn from the industry. While markets remain volatile and performance elusive, redemptions will continue to be an ongoing concern for managers throughout 2009.
• How the markets behave however is also a huge component in how fast the industry bounces back.
January and February this year, relative to the second half of 2008, have proven to be relatively good months for many hedge funds. We also feel that although managers and investors are both still experiencing redemptions, in many cases these have now slowed. A few good months performance for funds should have a calming effect on the industry. A few good quarters should have a very positive effect on the industry. Whether this will happen, we have yet to see.
Source for all charts in article: 2009 Deutsche Bank Alternative Investment Survey
