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Managing risk with alternatives

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Alternatives – particularly hedge funds – have struggled to deliver alpha. Low interest rates and crowded trading activity have hurt hedge fund managers’ returns, prompting investors to question their actual value and place in portfolios.

Hedge funds are pricey and the general fee model requires clients to pay a two per-cent management fee and 20 per-cent performance fee. As investors themselves become increasingly cost conscious, these fees are being scrutinised, and where possible pushed down.

Some investors have not even bothered with arguing on fees, preferring to put their money where their mouth is, and redeeming from hedge funds entirely. Well known pension funds in the US and Europe have faced pressure to exit hedge funds as the asset class has struggled to help them meet their liability obligations.

“Many European hedge funds have been humbled by big outflows in 2016, caused by disappointing performance or investor frustration about management fees,” said Justina Deveikyte, associate director at Cerulli Associates, a research company, speaking at FundForum in Berlin.

Flows are seemingly going into a number of asset classes as clients reallocate outside of hedge funds. Asset classes including private equity and infrastructure, which provide long-term returns, are increasingly popular. A survey by BNY Mellon of private equity investors last year found that 97% felt their managers had met or exceeded expectations, while 53% said they would increase allocations to the asset class.

Liquid alternatives, including alternative UCITS are also seeing flows. Such products offer cheaper hedge fund like returns although they are slightly more constrained in what they can invest in. In the US, some hedge funds have set up 40 Act products although inflows have not been as impressive.

Risk premia or smart beta products are also generating interest, but slowly. “One third of investors have no investment in risk premia but we expect this to change. Not all institutions are keen on systematic or risk premia. Conservative pension funds worry about the lack of data, while there are fears that some of these providers may suffer from capacity constraints, which could hurt performance,” said Deveikyte.

Investors are acclimatising to smart beta, mainly because it is more transparent and cheaper than hedge funds. Organisations are also keen to diversify their revenue streams and factor-based investment products such as smart beta offer a useful tool.  This is because alternative risk premia returns tend to be uncorrelated, which allows for greater performance consistency at the end client.

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