Traditional diversifiers and safe-haven assets such as government bonds look increasingly risky, with yields still at malnourished levels compared with historical averages and the threat of rising inflation. Investors have been forced to cast a wider net and have increasingly piled into alternatives products.
Sensing this growing client demand, traditional long-only houses have poured time and money into pumping out an array of products in the past decade, from equity long/short vehicles to absolute return strategies. The Investment Association’s Targeted Absolute Return sector, which celebrated its 10th anniversary in May, now hosts more than 122 funds from 66 fund providers.
At this stage, it’s fair to say the hedge fund has well and truly gone mainstream.
When you invest in traditional asset classes such as equities, bonds and property, you typically know what you’re getting yourself into. The same is not necessarily true for alternatives funds. The ‘alternatives’ label gets applied to very different kinds of funds.
“At its most basic level, a hedge fund starts life as a small business with an unconstrained ability to invest across asset classes and trading styles in order to generate returns” says Oliver Druce head of capital introductions, Europe at Société Générale.
“It will be up to the managers of the hedge fund to define their specific mandate, investment objectives, and imposing their own constraints in order to provide comfort to external investors.”
“The hedge fund universe is rich, dynamic and diversified”, he continues. “At one end of the spectrum there are very liquid managed futures trading strategies and on the other extreme you have structured credit hedge funds which may be invested in highly illiquid instruments, with the full range of asset classes and trading styles in between.”
Beyond compare
The huge population of funds housed under the alternatives umbrella has made the job of comparing products eye-wateringly difficult.
Druce estimates that the alternatives universe can be broken down into roughly 20 strategies. He and his team of 21, based in Société Générale’s offices across London, New York, Hong Kong and Tokyo, track about 2,500 alternatives funds.
But drilling down to individual sectors doesn’t provide much clarity either. A case in point is the IA’s Targeted Absolute Return sector. Richard Philbin, CIO of Wellian Investment Solutions, notes that this sector within a sector is a “catch all” that contains funds targeting all manner of expected risk-adjusted returns and, in many cases, they are using different underlying benchmarks, objectives, time frames and financial instruments.
“You need to look much deeper in this sector from a due diligence perspective,” he says. “You cannot compare Odey Absolute Return, for instance, with Standard Life Investment’s Global Absolute Return Strategy (Gars) or Kames Absolute Return.”
But recently, investor fervour for the alternative Ucits sector has taken a turn, as performance from a number of high-profile players has consistently disappointed.
According to Morningstar data, alternative mutual fund sales in the US plunged between 2013 and 2017, from net inflows of $53bn (€45.4bn) to $6bn. In Europe, net sales of alternative Ucits have fallen by one-third in 2017 from their peak in 2015.
While the IA Targeted Absolute Return sector was the best-selling asset class in May with net flows of £516m (€569.3m), comfortably beating fixed income (£360m) and equities (£264m), this marked the first time in over a year it had topped the IA’s sales chart.
“It’s much more of a buyer’s market than a seller’s market,” Druce admits. “Sophisticated investors are more fee sensitive and managers recognise that the traditional model of 2-and-20 is not always going to be the way they are going to be able to run their business.”
Problematic price tag
Fred Ingham, head of international hedge fund investments for Neuberger Berman’s alternatives investment management team, says that high fees and unrealistic risk targets are preventing many funds from delivering healthier returns.
The complexity and ‘sophistication’ of alternatives strategies has frequently been used to justify a higher price tag. Many hedge fund-type products execute daily trades, which ramps up transaction costs. A good chunk of alternative Ucits also charge performance fees.
Peter Sleep, senior portfolio manager at Seven Investment Management, adds that fees have also stayed relatively higher in the alternative Ucits sector because fund groups face less competition from passive products.
“Fund flows out of active into passive funds are very strong, which is why mutual fund groups are having to search around and develop alternative value-added income streams, something they can put into the market that can’t be replicated by passive funds,” he says. “People will charge what the market will bear.”
Of the giant alternative strategies that have struggled lately, “Gars is the 1,000lb gorilla” of the bunch, says Sleep.
As the biggest fund in the IA Total Absolute Return sector, the mega fund’s performance woes over the past three years have been heavily spotlighted in the press, much to the annoyance of the management team.
In 2017, there were £10.7bn in outflows for the mega fund, up from £4.3bn in 2016. The fund has shrunk from its peak size of £26bn down to its current £17.9bn.
Data from Kepler Partners shows the UK and Luxembourg versions of Gars in the bottom 10 macro alternatives strategies year to date as at 30 June 2018.
“Our thesis is that a lot of hedge fund products, particularly in the past, have been overpriced relative to the alpha it can deliver and to how much return it can deliver per unit of risk that it takes,” Ingham explains.
“The problem a lot of investors have is if you target a relatively low overall risk and have quite high fees, it creates a disproportionate drag on your expected return.”
Ingham says this effect is exacerbated in a low interest rate environment “where there is nowhere to hide” and investors do not have the benefit of decent carry from their cash positions.
Gars, Aims and Invesco Perpetual Global Targeted Returns all aim to achieve cash plus 5% per annum over a rolling three-year period. Newton Real Return aims to deliver cash plus 4% per annum over five years before fees and a positive real return over a rolling three-year period.
Old Mutual’s Gear has a slightly different agenda in that it aims to generate an absolute return above zero performance “irrespective of market conditions” over rolling 12-month periods. “In a lot of fund strategies if you can return half a unit of return for a unit of risk, you are doing quite well,” Ingham continues. “Not a lot of products are sold on those types of expectations.”
Dismal data
Data from Kepler Partners paints a dismal picture for returns across the whole of the alternatives board.
The report divides the alternative Ucits universe into eight indices based on strategies, including equity long/short, event-driven and macro, and tracks performance over the year to 30 June 2018.
Only one index (equity long/short) ended the period in positive territory, albeit sub 1%.
On average, the weakest-performing strategies have been managed futures, which houses Winton Diversified and Fulcrum Multi Asset Trend funds, followed by multi-strategy in which Pictet Diversified Alpha and Jupiter Merlin Real Return appear. The former index is down by 4.57% year to date, while the latter is down by 2.74%.
However, some alternatives Ucits have risen to the occasion this year, including several offerings from Crispin Odey’s hedge fund boutique.
After compiling performance data from the eight indices in the Kepler study, three funds from Odey’s firm made the list of top 10 alternative Ucits. Odey Giano European was the best performer in the six months to the end of June, with returns of 16.6%. The €173m European fund, which is run by the Brexit-backing billionaire himself, has gained 20% during the first half of the year, reversing several years of terrible performance.
Odey European’s gains have been good news for the Schroders multi-manager range, led by Marcus Brookes, which holds between 1% and 3% in the fund across its various portfolios.
Odey European has been the biggest driver of performance year to date of its alternative investments. Some of its fund of funds, such as the Schroder MM Diversity, have as much as one-third of their portfolio invested in hedge funds. Other portfolios in the range have zero exposure.
Robin McDonald, a fund manager for the Schroders range, says in aggregate the team has upped its exposure during the past 12 months.
Caveat emptor
McDonald says it is crucial for investors to understand what they are buying. The Schroders multi-manager team does not invest in Gars, Aims or Invesco Global Targeted Returns.
“While many funds might aspire to generate a positive return in all market conditions, we think it is just that – aspirational,” says McDonald. “There are no free lunches and absolute return funds have to take risk to generate a return like everybody else.
“On balance, if the market is more sympathetic than not to their views and positioning, they will stand a good chance of generating a positive return. But the opposite is also true.”
Rory McPherson, Psigma’s head of investment strategy, says picking the right alternatives funds requires “a forensic analysis of the manager, the process and then keeping very close scrutiny over any changes in order to maintain one’s confidence that it will do what is says on the tin”.
He says his best alternatives performer this year has been the Neuberger Berman Putwrite strategy, which provides defensive exposure to the US equity market.
“The managers are essentially selling insurance on the market in addition to investing in it,” says McPherson. “This means they can participate in the upside, but also get a cushion should the market sell off. These are attributes we think are hugely attractive given the fullness of valuation within the US market.”
