Why Investors Keep Coming Back to Hedge Funds

Last year’s disappointing hedge fund returns have not dampened investor demand for hedge funds.

Institutional investors surveyed by JPMorgan Chase & Co.’s capital advisory group largely said they planned to maintain or increase their overall hedge fund allocation in 2019, following a year during which 68 percent of respondents said their hedge fund portfolios underperformed.

A little over half intended to keep their hedge fund portfolios the same size, while about a third reported plans to invest more in hedge funds. Just 13 percent said they would decrease their hedge fund allocations this year.

The survey’s respondents were made up of 227 allocators including banks, consultants, endowments, foundations, family offices, funds of funds, insurers, and pensions.

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Asked why they invested in hedge funds, 88 percent gave “alpha generation” as a top-three reason for allocating to the alternative investment vehicles. But the surveyed investors noted that they have become increasingly concerned about crowding within the hedge fund industry, with more than 82 percent suggesting that there are too many hedge funds chasing too few opportunities to generate alpha. In addition, just under half of respondents said that hedge funds have been unable to deliver alpha on the short side.

Other top reasons for investing in hedge funds included portfolio diversification – the reason most cited by pension fund respondents – and the ability to access so-called niche opportunities.

Although the vast majority of surveyed investors did not plan to shrink the size of their hedge fund portfolios, nearly three-quarters did plan to reallocate to different managers this year. In addition, 62 percent said they would invest in different hedge fund strategies.

In particular, investors were eying higher allocations to global macro, emerging markets, and distressed credit strategies. When responses were weighted by assets under management, the top strategy was options and volatility arbitrage, followed by global macro.

Meanwhile, the respondents said they planned to make redemptions from funds of funds, commodity trading advisors and managed futures, and activist hedge funds. On an asset-weighted basis, surveyed investors planned to withdraw the most money from fundamental long-short equity hedge funds and long-only strategies.

Over half said they are either currently negotiating or looking to negotiate the fees paid to their hedge fund managers. In fact, their responses on fees caused JPMorgan to label the 2-and-20 fee structure “outdated”: Just 14 percent of polled investors said they paid average performance fees of 20 percent or higher in 2018, while only 5 percent paid an average management fee of 2 percent or higher.

Instead, the largest portion of investors reported paying average management fees ranging from 1.5 percent to 1.74 percent, coupled with average performance fees of 17.5 percent to 19.99 percent.

The most popular fee structures included reduced fees based on the size or length of the investment and hurdles for performance fees. Seventeen percent said they had moved to the 1-or-30 fee structure popularized by the Teacher Retirement System of Texas, up 6 percent the year before.