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.