Do Investors See a Quant Revival?

Investors haven’t been sending love to hedge funds in recent years, but that may be about to change.

Quantitative hedge funds, which have suffered performance troubles for the last five years, are the most likely to get new money from investors in the first half of 2021, according to a new report from HFM and the Alternative Investment Management Association, which was published Tuesday.

Thirty-one percent of investors surveyed for the report say that quant funds are at the top of the list for possible allocations, followed by arbitrage/relative value with 29 percent saying they are considering the sector. Long-short equity hedge funds were third on the list, with 27 percent of respondents considering upping their investments. The report included responses from 65 alternatives investors and 135 senior hedge fund professionals in the fourth quarter.

After a number of years of disappointing results, hedge funds performed well in 2020. Not surprisingly, investors have become bullish. In fact, almost half, or 45 percent, of investors plan to increase their allocations to hedge funds, according to the report. 

There’s a growing appetite for credit hedge funds, with 32 percent of respondents to the survey saying alternative credit could be a possible replacement for traditional fixed income, according to a statement Tuesday from HFM and AIMA.

Investors are increasingly concerned that with interest rates at record lows, possible losses on corporate and government bonds are larger than any possible upside. A big move by investors into credit hedge funds would be bad news for traditional bond managers.

[II Deep Dive: This Credit Manager Says Long Bonds Are Going to Sabotage Investors]

At the same time, only 33 percent of investors say they are satisfied with the performance of private credit last year. A number of respondents said many distressed opportunities were wiped out when the U.S. government stepped in to support markets and provide stimulus after the pandemic shut down economic activity in the spring.

Mitigating risk is the main driver behind institutional investors’ sentiment. “After a turbulent year, risk management is investors’ top priority moving into 2021,” according to the report. “This, combined with projections of anemic market returns and a ‘lower for longer’ interest rate environment bodes well for hedge funds.” 

Investors have pulled billions of dollars from hedge funds in recent years as managers have delivered disappointing performance. Yet the survey found the overwhelming majority of allocators (77 percent) use hedge funds to diversify their portfolios, with only 40 percent of allocators saying outperformance is the goal, according to HFM and AIMA.

It’s the opposite when allocators invest in private equity funds. Ninety percent of allocators invest in private equity for outperformance, compared to 41 percent using PE for diversification reasons. 

Hedge funds delivered good returns in 2020, but an analysis of the data points to managers taking more risk to do that. “Managers can expect to field conversations on this topic in 2021, when the bar for performance is set even higher than 2020,” according to the report. 

Liquidity and high fees, two areas of concern in recent years, were surprisingly low on investors’ list of priorities for 2021. Only 20 percent of allocators said “improving liquidity” was an investment objective this year, while 31 percent pointed to ‘reducing fees’ as a goal.

The ‘two and twenty’ fee model is alive and well. According to the report, a fee structure of 2 percent for management and 20 for performance is the median highest that investors pay for hedge funds. But that masks the wide range of hedge fund fees that managers charge.

“There is a wide dispersion, with some investors paying as little as 50 bps [basis points] in management fees and 5 percent in performance for their most expensive hedge fund product,” AIMA and HFM said in the report. 

Some managers are even raising fees as investors search for returns and protection against volatility. As survey respondent at a U.S. family office said, “I’m not driven by fees. I’m driven by alpha, returns, Sharpe and nothing else.”