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Aon Retirement and Investment Blog

Are Hedge Funds Still Worth It?

It can't have escaped the attention of investors that average hedge fund performance has been disappointing since the financial crisis. Returns have been obviously lower, both compared with those seen before 2008 and compared with equity markets. This has led many an investor to question the merits of having an allocation to hedge funds in their portfolio at all. Are they still worth it, especially given the high fees typically paid? A recent note by Aon Hewitt’s Global Asset Allocation Team answers this question in the affirmative, but with some important qualifiers.
Some of the drags to hedge fund returns appear permanent in nature, but others appear temporary and should lift. In the former group are two key changes over the past decade: first, a drag on returns is evident from the simple fact that the number of hedge funds has ballooned since the 1990s. This increase means that competition for investment opportunities is much higher. The second important reason is that their client base has shifted from private wealthy individuals who want high returns at high risk to institutions that prioritize diversification and consistency even if it means forgoing strong returns.  This change means that hedge funds are not necessarily going all out to get returns, but to get a steadier path of return.
Both these factors make it reasonable to argue that we should expect a little less from hedge funds in return terms than we might have done, say a decade ago. Our return expectations within our long-term capital market assumptions have indeed moved a little lower to reflect a view that these two 'structural' drags are unlikely to lift in the foreseeable future.
However, other drags to returns appear more transitory or cyclical. One of the key characteristics of market conditions in recent years has been the way that volatility has been artificially dampened and stocks and even asset classes have been moving together in unison ('correlations' in technical jargon). This environment has not played to hedge funds' strengths and has arisen as a result of extraordinary monetary policy by the major central banks. We think that these drags are not a permanent feature of markets and will gradually lift, helping to bolster returns. There are already some tentative signs that stocks and other asset classes are starting to move more independently of what central banks are doing. This makes us more optimistic that hedge fund returns may not prove quite the disappointment they have been over the last few years.
It is true that we are expecting a little less from hedge funds than earlier reflecting the changing nature of the hedge fund universe and what they are trying to do. Does this change undermine the strength of the case for hedge funds? In our opinion, no. For the crucial reason that the returns we expect from hedge funds, when weighed against the risk taken with hedge fund investments, still leave them looking attractive. Since conventional asset classes are already likely to have moved into an (at best) mediocre return environment amidst a rise in volatility, hedge funds will retain their considerable appeal. They may bring a steadier path of return and cushion portfolios against a rising risk that equities and bonds will disappoint. A crucial focus is whether hedge funds can deliver returns that do not rely on rising markets.  It is this attribute that may deliver the smoother return path we seek in a more challenging market environment ahead of us. Our view is that hedge fund approaches can indeed deliver this portfolio enhancement.
Hedge funds have not done badly in risk-return terms but you have to choose your funds well
Even with disappointing hedge fund returns for a considerable part of this time, portfolios with hedge funds represented generally did better in 'return for risk taken' terms versus almost any combination of equities and bonds over the last decade (see chart).

Source: DataStream and Aon, data as of June 2015
Note: The 20% hedge fund allocation is introduced at each point of the red line such that the relative positioning of equities and bonds is kept the same. For example, the 50% equity, 50% bond portfolio becomes 40% equity, 40% bonds and 20% hedge funds.

The all-important caveat to getting this performance from hedge funds is that investors need to be successful in choosing the right funds. Unlike some other asset classes, the hedge fund arena includes many, highly diverse strategies with extremely varied return and risk aims. In fact, there is a very wide dispersion of returns even for funds that all seem to employ the same strategy, as so much is based on the manager's skill. Our view is that since a key part of hedge funds' appeal is to be able to deliver returns from specialized skills, finding the right hedge funds is vital to making them 'worth it'.
Alongside this search for manager skill must be a set of robust views which guide the choice and mix of hedge fund strategies, depending on the market environment. Our views of low returns from global equities and bonds, alongside higher volatility across markets suggest a focus on macro discretionary and systematic strategies. These strategies generate returns by taking views on macro variables, such as interest rates and currencies, and are especially good at providing downside protection in times of equity market stress (see chart). Above all, they aim to generate returns that are not driven by wider market movements. Our historical empirical analysis of hedge fund returns (as detailed in the note) in different macroeconomic environments backs up this recommendation.

Source: DataStream, monthly average data from January 1991 to October 2015
Note: This corresponds to the average monthly returns for the hedge fund strategies in negative return months for the equity market as represented by the MSCI World in US dollars. In other words, the red bar represents the average of negative return months for the MSCI World and the other bars represent the average return for the corresponding months for those strategies.
In sum, we continue to like hedge funds' contribution to portfolios. Yes, there are performance challenges, but their key contribution of dampening portfolio volatility and bringing steadier returns in very different market environments is valuable. With the market environment gradually turning in their favor and some performance challenges likely to lift, hedge funds are already on their way to being better appreciated. That said, getting the best out of hedge funds is far from easy. The average hedge fund will not deliver the portfolio enhancement that we are looking for. Investors need to do better. Identifying the most skilled managers and putting together the right mix of hedge fund strategies is a must in making hedge funds 'worth it'.
Koray Yesildag is an asset allocation specialist in Aon Hewitt’s Global Asset Allocation Team in London.  

The information contained above should be regarded as general information only. That is, your personal objectives, needs or financial situation were not taken into account when preparing this information. Accordingly, you should consider the appropriateness of acting on this information, particularly in the context of your own objectives, financial situation and needs.Nothing in this document should be treated as an authoritative statement of the law on any particular issue or specific case, nor should it be treated as investment advice. Use of, or reliance upon any information in this post is at your sole discretion. It should not be construed as legal or investment advice. Please consult with your independent professional for any such advice. The blog content is intended for professional investors only.

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