This article examines how managers can and should help frame clients' expectations of hedge fund investments.

After a disappointing year for returns (although not nearly as disappointing as if investors had put money into conventional long-only equities and other assets), how should managers of hedge funds frame the conversation with clients and set expectations? To discuss these ideas is regular contributor Diane Harrison, who is principal and owner of Panegyric Marketing.

The editors are grateful for these insights even if they do not necessarily agree with all views of guest contributors. Readers who want to continue the debate should email tom.burroughes@wealthbriefing.com

Hedge fund investors and marketers seem glad to let go of 2018 and its disappointing finish, down by 3.41 per cent, a marked decline from 2017’s 11.99 per cent gain. And yet, 2019 markets started the year with an upswing, reflecting the hope that springs eternal in capital raising.

Alternatives managers will face the spring season with a renewed enthusiasm for the themes that underpin all their sales efforts: diversify, achieve non-correlation to other asset classes, and reduce portfolio risk overall while adding value. However, focusing on generalities and the same old sales pitches are not likely to yield the best results. It seems a far better plan to zero in on investor’s fears, concerns, and topics of interest in an effort to win them over.

Successfully wooing investors means hitting on themes that are of key interest and structuring the sales pitch to ask and answer the relevant issues which they have indicated are at the top of their minds. In February, Preqin released the Preqin Alternatives in 2019 report, which provides a wealth of data across alternatives sectors. Investors have spoken, and their wishes are clear as to what they want to hear about in investment discussions in the coming year. Let’s take a look at several highlights from the survey roundup.

The diversification effect remains in force
Preqin: 79 per cent of surveyed investors intend to maintain or increase their level of allocation to hedge funds over the next 12 months

Despite the disappointing returns hedge funds offered in 2018, investors will continue to hold hedge funds.  Long valued for offering a buffer against risk, hedge funds will attract investors in 2019 as volatility appears to be on the rise. The diversification construction might include funds with exposures across and within asset classes, or with debt holdings at varying maturities. In equities-based funds, varying global versus domestic equities, large, medium and small-cap stocks, active and passive investing, index versus individual funds will all also serve the diversification effort.

Whenever markets enter a period of higher volatility, the long-term commitment to diversification becomes more attractive to investors as a hedge against downturns. It bears repeating that the insurance protection diversification brings to a portfolio also tends to modify the returns overall. Losing components will act as a damper on rising components, but during periods of higher volatility, the portfolio swings will optimally be minimized. Fund managers can structure discussions to convince investors that their approach offers an attractive option for diversifying.

Volatility in vogue
Preqin: 29 per cent of surveyed investors plan to increase their exposure to macro strategies, the largest proportion for any strategy.

With volatility in the forecast, managers of strategies that exploit such activity can address investors’ fears and concerns over the growing risk threshold. Preqin’s survey concluded that in 2019: "…investors will look to strategies less correlated to market beta – macro strategies, CTAs and relative value strategies for instance. Volatility fears always spark renewed interest in the non-correlated strategies offered by these approaches, so managers in this area can anticipate opportunities to attract new investors in 2019."

In preparation for such discussions with prospective investors, smart hedge fund managers will arm themselves with an investment outlook and explanation of how their strategy works to exploit or mitigate the impact of forecasted market events.

There are some good tools readily available in research and other reports already published this year, such as the Guggenheim Investments report released in January, 10 Macro Themes for 2019, which provides ballast for the heightened interest in global macro players. The report analyzes macroeconomic data in support of ten themes which Guggenheim believes will have a significant impact on markets in 2019:

1    The Fed Will Pause to Start 2019;
2    Stocks Will Rebound in Response to a Fed Pause and Surpass Their Highs;
3    A Fed Pause Will Allow Excesses to Become More Pronounced;
4    A Historically Tight Labor Market Will Ultimately Call for More Fed Hikes;
5    10-Year Treasury Yields Will Rebound as the Outlook Improves;
6    US Economic Growth Will Cool as Rising Rates Weigh on Consumption;
7    Recession Will Be Avoided in 2019, but Watch Out for 2020;
8    Credit Spreads Will Widen as Recession Fears Mount;
9    The US Corporate Default Rate Will Rise; and
10   US Political Battles Will Undermine Confidence and Increase Risk Premia.

Compounding the fundamental data signals the report captures is the growing tension in the US political climate as the country heads towards the 2020 presidential election. As the Guggenheim report states: "With the 2020 election looming and voters appearing to prefer confrontation over compromise, bi-partisan efforts will be increasingly difficult, resulting in gridlock." This economic and political confluence of uncertainty will contribute to a rising level of volatility across many market segments.

Stocks seem mighty rich
Preqin: 59 per cent of surveyed investors believe we are at the top of the equity cycle.

Andres Cardenal posted an opinion piece in late January on SeekingAlpha.com, "Are Stocks Cheap Or Expensive? My Action Plan For 2019,"  that neatly captured an investor’s dilemma on whether or not the time is right to jump in for more of the stock market’s action. He suggests:

"Some widely followed valuation indicators are saying that US stocks are priced at dangerously high levels. The Cyclically Adjusted PE Ratio (CAPE Ratio) is a price-to-earnings ratio based on average inflation-adjusted earnings from the previous 10 years. The indicator is currently at 29.4, and it has not been this high since the levels before the Great Depression and the tech bubble. It's important to acknowledge that the market is relatively expensive from a long-term perspective, and the economic cycle in the US is quite mature. From current valuation levels, the main stock indexes could suffer severe draw downs if the outlook for earnings deteriorates in a material way."

If the equities markets are indeed poised for a decline, or at the least, some wobbling, then hedge fund managers ideally can position an argument for reallocation from equities to alternatives.

If you run it they will come
Preqin: 52 per cent of surveyed fund managers believe AuM will increase further in 2019.

Fund managers have a lot to be grateful for with the year’s positive jumpstart to the 2019 markets. A number of disparate factors are in place to help whet the appetites of managers ready to gather some new assets: consumer confidence is rising along with wages, there is increased belief that the Fed will not be raising rates in 2019 at the pace they had indicated in 2018, global central banks are lessening their control of markets, and investors, both institutional and high net worth, want to keep or increase their portfolio allocation to hedge funds.

Driving investors’ desire to look seriously at their hedge fund options is a need for non-correlation and increased activity throughout the equity markets, which work together to reinforce the goals of risk modification and defensive positioning against overweighting in equities. As the first quarter of 2019 winds down and markets heat up, savvy alternatives managers will keep their eye on the news developments that investors signal are meaningful to them and tailor sales efforts to address them as they arise.