Alt Investments
Should The High Net Worth Herd Move on From Hedge Funds?

Last week’s WealthBriefing poll of the week finds that the majority of wealth managers believe that no more than 20 per cent of a typical client’s portfolio should be allocated to hedge funds (71 per cent) and just 7 per cent think that hedge funds should make up more than 30 per cent of a typical client’s portfolio.
Last week’s WealthBriefing poll of the week finds that the majority of wealth managers believe that no more than 20 per cent of a typical client’s portfolio should be allocated to hedge funds (71 per cent) and just 7 per cent think that hedge funds should make up more than 30 per cent of a typical client’s portfolio. And acccording to Ted Wilson, consultant at Scorpio Partnership, as hedge funds become more commoditised as an asset class, net of fees they often do not provide a better return than more conventional investments: “The high net worth herd has in some ways moved on from hedge funds, although they still have a place in a balanced portfolio. Family offices are now looking to tracker-type investments for beta and to smaller, limited access long-only investments for alpha, which although they might have a hedge element to them, have lower fees and so provide more bang for their buck.” The view is echoed by Robert Ellis, senior analyst at Celent, the global financial services research and consulting firm, who believes that with over 8,000 hedge funds in the US and just six or eight strong strategies to choose from, hedge funds are finding it difficult to produce consistent alpha and non-correlated returns: “Intellectually, we should have known that the wonderful returns with little to no risk was too good to be sustainable. In the early 1990’s, when there were just a few hedge funds, they were able to achieve absolute returns by taking advantage of the long-only positions adopted by the majority because the hedge funds could do things that US investors and mutual funds couldn’t do.” Barclays Wealth recently surveyed high net worth individuals across the world and found that 14.2 per cent had invested in hedge funds in the last three years, but only 7.7 per cent were very confident in investing in this asset class. The research also found that men were more likely to invest in hedge funds than women (14.7 per cent versus 12.9 per cent) and were also more confident investing in them. However, the picture varied considerably across the globe with nearly a fifth of women (18.8 per cent) in the Middle East and Africa having invested in hedge funds in the last three years compared to under 10 per cent (8.3 per cent) in North America. William Drake co-founder of London-based multi-family office Lord North Street has also noticed that client attitude towards hedge funds varies according to region: “Many continental European families have been investing in hedge funds for longer than UK based clients and are generally more comfortable with higher allocations. Some UK families are inherently nervous about investing in something they feel they can never fully understand, although this is changing slowly as they get more experienced and enjoy the steady year-on-year growth achieved by a diversified blend of hedge fund managers.” The Merrill Lynch, Cap Gemini’s 2007 World Wealth Report notes that between 2004 and 2006, HNWs allocations to alternative investments, including hedge funds, dipped from 19 per cent to 10 per cent of their portfolios. Over the same period, assets allocated to real estate grew from 16 per cent to 24 per cent. The report does not interpret this as a sign that alternatives are falling out of favour, but rather a temporary, tactical move by investors pursuing the higher performance yielded by real estate in a year that was unfavourable for hedge funds as market volatility subsided. It forecasts a greater allocation to alternative investments in 2008. Mr Wilson points to Scorpio Partnership’s recent research comparing actual allocations to hedge funds by private banks with their model portfolios: “Across income, growth and balanced portfolios, actual hedge allocations were lower than model portfolios, perhaps reflecting clients’ dislike of the expensive fees charged by run of the mill hedge funds. The low hanging fruit has gone and returns from hedge funds and private equity are not what they once were. Property is the ‘mot du jour’, but also has a depth of supply of good opportunities that less tangible investments don’t have.” Mr Ellis references a 2005 study by a Princeton professor (Malkiel and Saha) which showed that because hedge funds have no legal requirement for standardised reporting, they overstate their results by as much as 500 basis points on average. This is due in part to ‘backfill bias’ where hedge funds report backtested information as actual performance. Another is ‘survivorship bias’, where hedge funds that perform badly or cease to exist are excluded from performance measurement, skewing overall returns upward. “I believe that hedge funds’ ability to charge 2 per cent fees and 20 per cent profit based on exceptional performance is rapidly coming to an end,” says Mr Ellis. “I am a fan of hedge funds for organisations that cannot adopt certain strategies and where the only way to gain this exposure is to use a hedge fund. Examples include pension funds using hedge funds for a short-only strategy or for managed commodities futures. That said, hedge fund managers should be paid more normalised fees for such arrangements.” Fredrik Nerbrand, head of Global Strategy for HSBC Private Bank, believes that it is the quality of hedge funds that is important: “Successful hedge fund investment depends to a large degree on who you’re investing with and we have access to very large and high quality hedge funds. Our clients have had a lot of money in real estate, but we do not believe that this now offers appropriate risk adjusted returns and is overvalued in some parts of the world.” Mike Hollings, chief investment officer, Ansbacher says that since the firm’s investment management business was founded in January 2002, it has made relatively high allocations within its client portfolios to hedge funds: “The generation of absolute returns has been a central theme of our investment philosophy over that time. Post tech bubble crash many investors came belatedly to realise the advantages offered by hedge funds in managing downside risk and as a result, use of alternatives within portfolios has grown substantially.” Mr Drake also believes that given the general gloom about the prospects for bonds, combined with a feeling that equities have had a good run, that hedge funds can seem an attractive alternative “which achieve returns half way between bonds and equities with bond like volatility”. According to Mr Nerbrand, the ideal allocation to hedge funds depends on the spending and yield requirements of the individual concerned: “A lower proportion of a HNW individual’s portfolio should generally be allocated to hedge funds as they are more likely to require yield than an Ultra-HNW individual. The further up the wealth spectrum you go, the fewer the liquidity restraints. For a HNW individual I would subscribe to somewhere between 18 and 25 per cent of their portfolio, but for UHNW individuals it could be anywhere up to 40 to 50 per cent.” Mark Dowell, head of Portfolio Management at Butterfield Private Bank says that where hedge funds are deemed appropriate for a particular client, he would typically allocate 1-10 per cent of a portfolio to hedge funds as part of a wider exposure to “alternative investments” including property, private equity and commodities. According to Mr Dowell, diversification and liquidity are crucial at both asset class level and within each asset class. “10 years ago such ‘alternative investments’ were considered to be high risk”, says Mr Dowell. “However, when considered in the context of a diversified portfolio, the marginal risk of including ‘alternatives’ can be negative. Given the low correlations to more traditional asset classes, hedge funds in particular, can add value and improve the overall risk/return profile of a client’s portfolio.” Mr Hollings believes that as highlighted by recent events in the US, the use of leverage to boost returns also needs to be carefully monitored, particularly in credit strategies. Whilst acknowledging that there is no, “silver bullet” in investment, he says that hedge funds and structures will, in his opinion, continue to merit increased allocation within client portfolios: “As the number of hedge funds has increased, so returns have begun to compress and the skill now lies in finding genuine ‘alpha’ producers rather than beta dressed as alpha and blending available asset classes to produce optimal returns within carefully managed risk profiles.” “As Ben Graham famously said: ‘the essence of investment management lies in the management of risk, not the management of returns’, and alternatives allow us to focus on managing risk more effectively”, concludes Mr Hollings.