Pension funds and endowments have been the backbone of the hedge fund industry for much of the past decade. But many of these institutional investors are now turning away from the $3tn-in-assets sector, dismayed by high fees and relatively lacklustre returns.
“We got out of most of the hedge fund portfolio,” said Scott Wilson, chief investment officer of the $8.9bn endowment fund at the Washington University in St Louis, Missouri. “We don’t want any investment just for the sake of having that investment.”
Since Mr Wilson’s appointment two years ago the fund has slashed its allocation to hedge funds from about 20 per cent of the portfolio to little over 10 per cent. He plans to rebuild that share to about 15 to 20 per cent over time, but will do so cautiously. “It’s not that all hedge funds are bad, but you have to be very careful in the selection process,” he said.
The reshuffle comes after years of largely uninspiring performance from the hedge fund sector. Managers have underperformed the S&P 500 stock index every year since 2009, both in rising and falling markets. Last year provided hedge funds with their best returns in a decade, but they were still well behind the market.
The current bull run in stocks — the longest in history — has increased the appeal of tracker funds, which charge much less than hedge funds. Interest in private equity and debt has also boomed as investors have looked beyond expensive public markets for opportunities.
Mike Powell, head of the private markets group at London-based USS Investment Management, which manages the £68bn Universities Superannuation Scheme, said it had reduced its hedge-fund holdings to less than 2 per cent of assets, from 4 per cent five years ago.
The pension fund is also planning to further reduce the number of hedge fund positions “to focus only on those that offer strategic alignment with our investment priorities and clear value-for-money”, said Mr Powell. The key problem with respect to hedge funds has been “the continued disappointing performance . . . at a time when fees have remained high”, he said.
UK local authority pension funds, including West Yorkshire Pension Fund and Hampshire Pension Fund, are also turning away from the sector. Hampshire is selling out of a hedge fund portfolio with Morgan Stanley, in favour of a private debt mandate with JPMorgan.
“The current low volatility environment has made it difficult for hedge funds to perform and, as a result, [investors] are asking questions on how they allocate in a way that they previously did not,” said Dan Nolan, a director at Duff & Phelps, a professional services group.
Tracking institutional investors’ appetite for hedge funds is tricky. Investors in aggregate pulled $43bn from hedge funds last year, their second-highest withdrawal since 2009, after $38bn of withdrawals in 2018, according to data group HFR.
Since 2015, the share of total hedge fund assets coming from public and private sector pension funds, endowments, foundations and insurance companies has slipped from 71 per cent to 67 per cent, according to data from the Alternative Investment Management Association, a London-based body.
Any sign that institutional investors are moving out en masse would be a blow for a hedge fund sector that has grown dependent on their cash, after many wealthy investors and private banks pulled back during the credit crisis.
“It is true there has been a waning of interest over the past two years,” said Jack Inglis, AIMA’s chief executive. “However, recent investor surveys suggest that sentiment for 2020 has turned positive and institutional investors are stating an intention to increase their allocations once again.”
The data is not conclusive. A Deutsche Bank survey early last year of investors with $1.7tn in hedge fund assets found that 42 per cent of pension funds had increased their exposure, while just 14 per cent reduced it.
However, an EY study, based on 62 interviews with investors managing $1.8tn in assets, found that institutional investors’ allocation to hedge funds had dropped to 33 per cent of their alternative investments last year from 40 per cent in 2018.
Some big-name institutions had already pared back their allocations. In 2014, US public pension fund Calpers said it would stop investing in hedge funds, while the following year Dutch pension fund PFZW said it had “all but eradicated” its hedge fund positions.
Others are considering similarly radical measures, after two years of losses in the past five. “There’s a very strong recency bias in all investment decisions,” said Sanjiv Bhatia, who runs the Pembroke Emerging Markets hedge fund in London and previously managed emerging-markets portfolios for Harvard’s endowment.
“People chase returns, and it’s no different at the top of pension funds,” he said. “People up there are not more visionary.”