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Can Absolute Return and Hedge Funds Turn it Around?

Date: Thursday, April 24, 2014
Author: Cherry Reynard, Morningstar

Hedge funds have seen their slowest start to the year since the financial crisis in 2008 and yet investors continue to allocate funds to the asset class

Hedge funds have seen their slowest start to the year since the financial crisis in 2008, according to figures from Preqin, and yet investors continue to allocate funds to the asset class. A similar situation is being seen for the targeted absolute return sector, where returns have been disappointing, but investors continue to invest. What is the likely rationale behind continuing to support a weaker asset class?

According to Preqin, the average hedge fund has gained just 1.23% in the first quarter, of 2014, the lowest first quarter return since the start of 2008. Areas such as technology and financials have been hit hard, and many funds have been over-exposed to market momentum, which has weakened since the start of the year.

Yet the sector continues to see significant inflows, particularly into equity strategies. Data from eVestment shows that investors allocated $18.3 billion of new capital to hedge funds in March, bringing total net inflows for 2014 to $55.1 billion. Flows into equity strategies were the highest since the second quarter of 2007.

Performance of the targeted absolute return sector as a whole has also been disappointing, with the average fund up just 3.57% over the past three years, behind among others the UK All Companies, UK Equity income, Strategic and Corporate Bond sectors. Yet fund flows have remained robust.

Also there are signs that expert investors are allocating more to the sector. David Coombs, head of multi-asset investment at Rathbones, has been topping up his holdings in equity-focused absolute return funds as equity markets have risen and he has found less value in conventional equity funds.

The aggregate data for the hedge and absolute return funds masks a more nuanced picture underneath. Fund flows in the targeted absolute return sector have been concentrated in a small number of top-performing funds such as the Newton Real Return (rated Bronze) or Standard Life Global Absolute Return Strategy fund (currently under review by Morningstar analysts). The same is true among hedge funds. Equity long/short strategies have gathered $41.7 billion of the $55.1 billion in flows in the first quarter. In contrast, macro strategies have seen outflows of around $5 billion.

The greater allocation to long/short equity hedge funds in particular suggests that investors are increasingly reacting to changes in the equity market. In theory, this should be the perfect time to allocate to alpha generative absolute return-focused funds equity markets seem expensive and there are no prevailing sector themes. It should be a market in which stock pickers are best placed to generate returns.

There are sound reasons why the performance of hedge funds/absolute return funds has looked relatively weak. The risk on/risk off markets of recent years, which have included strong cyclical versus non-cyclical biases in markets, have often not suited stock-picking managers. Now, however, managers point to an increasing differentiation between the stock performance of different companies. This marks a turning point in the cycle and should see absolute return/hedge fund managers start to perform better relative to their long-only peers. Investors appear, increasingly, to recognise this.

However, the type of absolute return funds that have performed best over the past few years may not necessarily be those that will perform best in this new environment. Those that have performed well have tended to have significant market exposure. Unless the manager times their exit skilfully, this type of fund is unlikely to provide significant protection should markets reverse.