What Do Allocators Like in Choosing Hedge Funds?

Hedge funds have continued to bleed invested money amid mediocre returns, but they maintain a loyal following among asset allocators. What do these hedge fund devotees look for nowadays in this asset class?

Consulting firm Agecroft Partners polled 300 allocators to uncover what investments they see as the best bets in 2024, and which less so. These investors, wrote Don Steinbrugge, Agecroft’s founder and CEO, in a report on the findings, “provide good guidance on the strategies to which assets will flow.”

Right now, to be sure, investment dollars are flowing away from hedge fund coffers. In January, investors pulled an estimated $14.3 billion from hedge funds, the second biggest net outflow to begin a year since 2009, according to Nasdaq eVestment, the exchange’s research arm. For the first quarter this year, hedge funds were up 5.6%, less than the five-year average of 6.9%, per Hedge Fund Research.

Nevertheless, public pension plans hold 6.5% of their assets in hedge funds, an increase from 3.3% in 2010, the Public Plan Database reported. Some investors actually have renewed faith in hedge funds: The California Public Employees’ Retirement System, which dumped its $4 billion hedge fund allocation in 2014, is weighing a return to the class.

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So here is how the hedge fund believers are assessing various hedge strategies this year, compared with a survey two years before, the Agecroft report indicated:

Long-short equity remains the most popular strategy, as the choice of 65% of respondents, up a percentage point from 2022. Here, a fund manager offsets a long position on underpriced stocks while shorting overpriced shares, often by ranking the names in the S&P 500, employing recent past performance.

As Steinbrugge argued, investors are encouraged by positive market “sentiment regarding fund managers’ abilities to generate alpha via stock selection.” He pointed to large valuation disparities between growth and value stocks, as well as with large and small or mid-cap stocks. These gaps, he went on, make “many investors believe both are great environments for active managers.”

Equity market neutral had the biggest increase, up 16 points to 63%. The aim of this strategy is to log a gain independent of the overall market’s direction. A variant on the long-short strategy, it pairs long and short positions, which it determines via statistical methods using historical correlations over many years, and derivatives. Enthusiasm about managers’ stock selection prowess, amid high valuations, is powering this strategy, Steinbrugge contended.

Fixed income also found favor, jumping 11 points to 46%. This comes as the bond market overall is dragging it, with the Bloomberg U.S. Aggregate in the red this year by 0.08%. But currently high interest rates are enticing, he noted.

ESG funds are dimming in appeal, to 19% this year from 38%. Steinbrugge did not pinpoint political controversy over environmental, social and governance investing for the decline. Rather, he blamed confusion over what constitutes an ESG investment, writing that “the criteria are broad and vary from one investor to the next.” He added that he expects the gauges to become more standardized over time.

Cryptocurrency and other digital assets also have less appeal now, ranking as the choice of 24% of those surveyed from 41%. This seems counterintuitive, given crypto’s run lately: Bitcoin is up 66% this year. The problem, Steinbrugge said, is that many people do not understand crypto. This too shall improve with time, he declared.

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Tags: Agecroft Partners, Cryptocurrency, Don Steinbrugge, ESG, Fixed-Income, Hedge Fund Research, Hedge Funds, long/short, market neutral, Nasdaq eVestment

Insurance asset managers overwhelmingly plan to invest in alternatives this year, increasing allocations to private debt and decreasing allocations to real estate equity, according to new research from Mercer and Marsh McLennan, published in the firms’ 2024 global insurance investment survey.

Mercer surveyed 84 respondents across 22 markets, 36% of which are life insurers and 64% non-life insurers. Thirty-six percent of respondents were from Europe, 20% from the United States, and 14% from Canada.

“As insurers strategically deploy excess capital in support of their portfolio objectives, our data shows that insurers intend to redeploy cash in public fixed income and private debt investments. Selecting skillful managers is essential for these asset classes, particularly later in the credit cycle. Investors should seize the moment to capitalize on opportunities while managing associated risks,” said Eryn Bacewich, principal and senior investment consultant of insurance investments at Mercer, in a statement.

Private Markets

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According to the survey, 39% of respondents say they plan to increase their allocations in the private markets this year. In total. 73% of respondents said they already invest in the private markets or plan to do so this year.

Among those that do not, illiquidity concerns and a lack of resources to assess investment opportunities were leading reasons to not make allocations to private markets.

Of those increasing their allocations to private market investments, the most popular asset allocations were investment-grade and sub-investment-grade private debt, with 27% and 23% of insurers respectively increasing allocations to these asset allocations in the past 12 months.

In the next 12 months, 32% of insurers surveyed expect to increase their allocations to investment-grade private debt and 21% to sub-investment grade. Only 1% of respondents said they plan to decrease these allocations in the next year.

The asset class that saw the largest decrease from insurers in the last 12 months was real estate equity, with 20% of insurers decreasing these allocations, although 17% of insurers surveyed said they would increase allocations to the asset class. Over the next 12 months, 15% of insurers say they will decrease their allocations to real estate equity, the highest decrease of all private market assets, 18% say they will increase this allocation.

Insurers’ appetite for private debt is driven by higher rates. “On the one hand, higher cash returns raise the bar for investing in private debt. On the other hand, private debt spreads continue to be meaningful, and all-in yields are typically well above those of high-yield bonds and leveraged loans,” said Denis Walsh, head of Insurance Australia at Mercer, in the report.

Barriers to Private Markets Investing

Of the 26% of insurers not making or planning to make investments in private markets, the biggest barrier was the inability to tolerate the level of illiquidity associated with private markets and alternative investments. Approximately 59% of insurers not making private investments say this was one reason they have not invested in these markets.

Another of the biggest challenges to insurers when making investments in the private markets was high fees, with 58% of respondents saying this was among their main challenges. According to the survey, 47% of insurers outsource their private market investments to external managers.

“Insurers rotating out of public fixed income into private debt are likely to have experienced a significant increase in costs. Private debt investments will mean higher fees, but insurers’ net-of-fees returns are likely to be higher, as are their returns on regulatory capital. We also anticipate the market for co-investments to continue to develop, which will provide larger insurers the opportunity to invest alongside a manager with no management fees,” said Chris Tschida, U.S. Head of Insurance at Mercer, in the report.