Why Hedge Funds Continue to Grow Despite Numerous Challenges

Although returns have lagged equity indexes, hedge funds can improve a portfolio’s risk-return profile.


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Investors’ desire to beat the markets while mitigating risk has helped hedge funds not just maintain but also increase their assets and market share well beyond levels seen prior to the 2008–’09 financial crisis. This expansion has occurred in the face of challenging industry performance, regulatory changes and investors’ heightened concern regarding liquidity and fees.

As the industry has matured and developed, these factors have affected all investors. So are hedge funds worth the exposure? Although it is true that hedge fund returns have not kept up with traditional assets in the current bull market, the asset class should be measured by its contribution to the risk-return profile of the overall investment portfolio, not against traditional benchmarks. Hedge fund portfolios — including equity-focused portfolios — are not 100 percent long-only, making the comparison to long-only indexes a faulty one. For example, for a diversified portfolio with a look-through net equity exposure of 30 percent or less, it would mean that for every dollar invested, only 30 cents would be exposed to equity market — or beta — risk. Such portfolios are likely to trail in equity bull markets that are driven by unconventional monetary policy while providing protection in down markets.

That said, a major concern for clients continues to be what implications regulation may have on their allocation to hedge funds. Changing regulations are having both a negative and a positive impact on the industry.

On the negative side, some regulations have the potential to restrict certain investment opportunities. Prime brokers are becoming more selective in doing business with smaller hedge funds, preferring to engage with larger managers, as they tend to be more profitable. This can make new hedge fund launches difficult, possibly constraining the universe of emerging managers.

Other regulatory changes, however, appear to be having more of a positive impact. Rules prohibiting proprietary trading, for example, have prompted talented managers to spin out, opening their strategies to outside capital.

Regulation has also contributed to industry innovations that are helping providers address specific client needs, such as innovative long-duration strategies designed to take advantage of illiquidity premiums resulting from the pullback of bank capital. On the other hand, for some liquidity-constrained investors seeking to incorporate the risk-return characteristics of hedge funds into their portfolios, strategies such as liquid alternatives may be a partial solution. For large hedge fund managers considering liquid alternative mutual funds as a new way to put their years of expertise to use, Securities and Exchange Commission registration requirements that are part of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 have lowered the barriers to entry. A similar trend is happening in Europe, where UCITS regulation allows investors to access liquid alternatives in a regulated format.

Although a small but vocal number of large investors have exited hedge funds, many more are adding to existing allocations or creating new ones. According to J.P. Morgan Capital Introduction Group’s 2015 Institutional Investor Survey , 94 percent of institutional investors plan to maintain or increase hedge fund exposure this year. This has been reflected both in the strong flows that have driven industry assets to an all-time high of $2.8 trillion and in several large hedge fund commitments recently announced by state pension plans.

John Anderson is managing director of hedge fund solutions at J.P. Morgan Asset Management in London.

See J.P. Morgan’s disclaimer.

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