Amid Muted Returns, a Plan to Reshape Hedge Funds

Given the sustained equity bull market and muted market volatility, the low level of alpha that hedge funds have delivered in recent years is not surprising, Willis Towers Watson says in a new report, “Hedge Funds: A New Way.”

The consultancy says that hedge funds have not taken on sufficient risk to deliver attractive performance and that they face several headwinds.

Hedge fund managers have turned their attention to short-term performance in order to prevent jittery investors from redeeming their assets. “This has led them to reduce their investment risk appetite in favor of managing ‘enterprise risk,’” Willis Towers Watson says. “Enterprise risk is the risk that managers spend too much time focusing on the stability of base management fee revenues that than delivering against performance objectives for clients.”

Secondly, other investors are increasingly using specialist alternative beta strategies in their portfolios, essentially crowding the hedge fund opportunity set.

Thirdly, hedge fund returns are suppressed by high and poorly structured fee schedules. Lastly, quantitative easing programs have dampened dispersion and volatility, which hedge funds rely on to extract alpha.

Despite these headwinds, which will continue to persist, Willis Towers Watson says, hedge funds have a place in institutional portfolios since they have a largely unconstrained investment managed.

The consultancy lays out “new ways” that hedge funds can be managed, starting with isolating the unique, specialist skills of a manager, rather than allowing them to be generalists. Next, it suggests that hedge funds strive to create better structures and new products. Lastly, it says that hedge funds should lower fees and make them transparent.

To build a better portfolio, it says that considering a client’s portfolio as a whole is key and that hedge funds should contribute an appropriate level of risk and return. “A hedge fund should allocated to a concentrated mix of funds and not overly diversify the exposures,” Willis Towers Watson says.

The consultancy also believes that with high levels of uncertainty in the markets continuing to rise and downside risks increasing due to volatility, the market for hedge funds is improving. “With rising interest rates and the potential for slower global growth, we foresee greater downside risks over the medium term. This would make equity and credit markets vulnerable to price falls—providing a better environment for hedge funds to potentially exploit their unconstrained mandate.”

In conclusion, the consultancy urges hedge funds to change their approach to investment management.