4 reasons why hedge fund allocations are on the rise

In 2023, our private bank and private wealth partners invested more in hedge funds via our platform than any year since 2007, and the feedback (and early 2024 allocation pace) suggests that this will continue in 2024, for a range of market and product reasons. 

On the market side, two trends stand out prominently over the last 48 months. Firstly, there's been a notable increase in interest rates, rising by approximately 5%, as a response to inflationary pressures. Secondly, both bonds and equities experienced simultaneous declines in 2022, highlighting a diversification failure when holding both asset classes, albeit this partially reversed in 2023. 

Asset allocation implications

These trends carry implications for asset allocation strategies, particularly emphasizing the importance of diversifying holdings, such as hedge funds. Today, US data with strong growth and lower-than-expected price pressures seems to fit the Goldilocks narrative; markets appear to be priced for perfection and the tails of the distribution quashed, but in this uncertain environment, we’re keeping a close eye on five key trends:

1. defaults & delinquencies,
2. inflation,
3. changing single-name equity trading dynamics,
4. fiscal deficits, and
5. Japan vs China, which we believe might impact the future direction of markets (we’ll revisit these 5 trends in greater detail in a future wire). 

Despite varying views on market direction for the upcoming year, ranging from how many cuts the Fed will make to whether Chinese policy will stabilise their markets, among CIOs and allocators, there's a unanimous consensus on why hedge fund allocations are on the rise:

1) Downside protection

Hedge funds provide meaningful downside protection and capital preservation, especially during stressed market periods. Stringent risk management policies are put in place to curtail losses, most evident with Multi-Strategy Platforms (‘multi-strats’) adhering to strict drawdown protocols, which result in automatic reductions in allocated capital to underlying portfolio managers with poor performance. Additionally, hedge funds deploy a range of other tools to control risk:

• Multi-factor style models that invest and re-allocate between different factors (size, quality, momentum etc.)
• Historical scenario and stress testing suites
• Imposing limits on liquidity, maximum position sizes, exposures, etc.

Observing the drawdowns of our client’s hedge fund portfolio against local equities and global bonds over the last decade (refer Figure 1 below), it is clear that the magnitude and length of drawdowns are a fraction of market drawdowns (the AAAP asset-weighted index in this and subsequent diagrams is the asset-weighted average performance for all clients on our platform, and represents the actual net performance across their hedge fund portfolios, with no adjustments – the funds are curated and diligenced by us, but our private wealth clients drive the allocation decisions). Smaller drawdowns for hedge funds act to reduce volatility at the overall portfolio level and provide a counterweight during challenging periods for markets.

Figure 1: Drawdown Recovery AAAP Asset-Weighted Index vs. Equities and Bonds (2013 to 2023)

2) Enhanced diversification

Hedge funds excel in managing diversification across multiple dimensions, including strategies, asset classes, markets, time horizons, and styles, and can do so seamlessly in real time. Part of the appeal for the large multi-strategy ('multi-strat') funds, which have dominated hedge fund inflows and headlines for the last 2 years, is that they leverage their expertise across different asset classes and swiftly reallocate capital as market conditions change. 

A large multi-strat fund might have 300 pods globally, made up of the best traders across all asset classes, strategies, markets and instruments, with a command centre that cuts losses, reallocates capital and chases winning trades and strategies with a speed and efficiency that can’t be replicated in other environments. 

The quality of traders at these funds, and their compensation, is well documented and extends well below the largest names – one of the mid-sized multi-strat funds we’ve allocated to for many years has 1/3 of their portfolio managers with PhDs, 80% of them from ivy league colleges. Their dynamic approach enables them to capitalize on emerging opportunities like shifts in commodities markets due to supply-chain issues or short-lived trends such as SPACs at the end of 2020. The SPAC trade has become a challenging one in recent years, a number of funds we allocate to made outsized returns on SPAC arbitrage strategies, and exited the sector seamlessly before the risk premia disappeared, a timing feat not easily achieved by individual investors, or wealth advisors.

3) High risk-adjusted idiosyncratic returns

Hedge funds consistently deliver high risk-adjusted returns, surpassing those of equities as evidenced by Sharpe ratios (the incremental return generated for every unit of additional risk), whether indices or individual securities

Figure 2: Annualised Sharpe Ratio AAAP Asset-Weighted Index vs. Equities (2013 to 2023)

The nature of hedge fund investments results in balanced, consistent, and durable returns across market cycles. This is accomplished through rigorous and repeatable investment processes ranging from security selection and trade structuring to portfolio construction and sizing of trades. Hedge funds capture sources of inefficiencies in the markets, including:

• Technical- forced buyers or sellers, for example during stress periods
• Analytical - through weighing information differently to the market
• Behavioral - created by human biases in markets such as myopic over-extrapolation of recent trends
• Informational - by paying attention to the relevant information, as well as being able to act fast in complex situations

4) Reduced reliance on market direction

We’re seeing increased allocations to funds with low directionality, with our partner CIOs and strategists feeling less confident about relying on market direction to generate returns, reflecting a shift away from relying solely on market beta for returns. Specialised funds that are consistently generating positive returns in sectors and regions that have had pulled down index returns in recent years have gained traction. Some of the specialty funds that have been popular amongst our allocator partners include a healthcare fund that has generated net annual returns in excess of 26% since inception in 2018, vs -2% annually for the Russell 2000 healthcare index, and an Asia Pac L/S equity fund that has annualized at 17% net since launch in 2017, vs a negative annual return for the MSCI APAC ex-Japan index. 

Key Takeaways

In light of the changing financial landscape, two key takeaways recur across our allocator discussions, and are driving increased hedge fund allocations for investors:

1. Given the current environment, where risk-on and risk-off dynamics are evolving, substituting beta with alpha in portfolios should prove to be advantageous.
2. Between diversification benefits and superior downside protection, hedge funds can play a meaningful role in multi-asset portfolios, acting as a ballast to traditional equities and bonds

In the coming period we’re looking forward to engaging with the private wealth and family office sectors in Australia. We have a somewhat unique position, sitting between leading private banks and the leading hedge funds globally, and a perspective on market cycles informed by having held this position for 20 years. 

We’re happy to share what we’re seeing both across the hedge fund and allocator markets, and will drill down on some more specific and technical topics in future, including market views and key trends for allocators to watch, introductory/educational content on the hedge fund sector, what we’ve learned about hedge fund diligence and fund selection, and investment theses and views from some of our specialist and regional funds.