Institutional investors are beginning to swap out their hedge fund allocations for multi-asset strategies that offer similar diversification benefits, but without the high fees.
Their growing preference for customized investments in a broad mix of assets has been one of the few bright spots for traditional fund managers struggling to compete with low-cost passive funds. Investors like actively managed multi-asset strategies because they offer a cheaper way to increase risk-adjusted returns compared to hedge funds, according to a Schroders research report for clients that has not yet been publically released.
Multi-asset portfolios keep costs low by including simple index funds, actively managed funds and factor-based investments that provide exposure to everything from value stocks to so-called alternative risk premia typically tracked by hedge funds. Traditional fund managers have been stepping up their game by investing in new technology and the data analysis needed to continue building out such offerings as they gain traction with investors.
“Hedge fund fees are harder to justify these days except where investors have a high degree of conviction in their ability to generate alpha,” said Johanna Kyrklund, global head of multi-asset investments at U.K.-based Schroders. “Certainly, when it comes to increasing diversification and delivering a smoother path of returns, institutional investors are looking to build alternative approaches.”
Many institutional investors have historically allocated capital to hedge funds because they offered an uncorrelated source of returns, according to Kyrklund. But correlations between hedge funds and equities have been increasing steadily since the early 1990s, while hedge fund performance has declined, she said.
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During the second quarter, seven percent of public pension plans globally reduced their allocations to hedge funds, while 16 percent increased their multi-asset investments, according to data from Schroders. Only 2 percent of public pensions expanded their hedge fund allocations during the period.
In its report, Schroders explores the rationale for investors replacing their hedge fund portfolios — or part of them — with multi-asset investments, and notes that the strategies can be fundamentally similar.
“On the face of it, these more flexible multi-asset strategies have similarities to some types of hedge funds in the sense that they generate returns through investing their portfolios across different asset classes and strategies, eschew the use of benchmarks in portfolio construction in favor of outcome-oriented objectives, and are focused on generating strong risk-adjusted return with a lower reliance on traditional equity beta,” Schroders said in the report.
Other asset managers have seen investors dumping hedge funds in favor of multi-asset portfolios.
“That is a really strong theme that I see coming through,” said Matthew Merritt, global head of multi-asset strategy at Insight Investment. “When you look at the return and volatility characteristics of these multi-asset portfolios and then compare them to a range of hedge funds, they’ve performed well and managed risk better.”
According to Boston Consulting Group’s 2017 report on the global asset management industry, $19 trillion, or 20 percent, of assets will be in solutions-based strategies such as multi-asset by 2021. That’s up from 18 percent last year.
While Merritt points to “a blurring of the lines between multi-asset and what a macro hedge fund would do,” he says the lower fees offered by traditional asset managers may be the deciding factor for investors.
“With the fee structure of these traditional portfolios in a completely different world than hedge funds, investors are recognizing that they are a good alternative,” said Merritt.
That doesn’t count hedge funds out of the picture, though. Kyrklund stresses that with the savings from multi-asset, institutional investors can then justify paying high fees for a smaller portfolio of hedge funds that have shown they can generate uncorrelated returns and can’t be replaced by factor-based funds.