The financial media would have you believe that hedge fund investors will soon pull their money from these overpriced vehicles that have underperformed the S&P 500 index in recent years.
Yet in February, hedge funds enjoyed their strongest monthly inflows since before the 2008 financial crisis, the majority coming from sophisticated institutional investors.
In a recent paper, Donald Steinbrugge, founder and managing partner of Agecroft Partners, a hedge fund consulting and marketing firm, analyzed the disconnect between media reports and investors’ attitude and behavior.
Steinbrugge wrote that institutional investors don’t use the S&P 500 as a benchmark for the performance of their diversified multistrategy hedge funds because hedge funds are not an investment asset class. “They are a legal structure that represents a highly divergent group of strategies, many of which have little to no equity exposure.”
Comparing a hedge fund portfolio consisting of CTAs, global macro, structured credit, market-neutral equity, distressed debt, event driven investing, volatility strategies and long/short credit managers with the S&P 500 makes as little sense as comparing an average mutual fund with the index, he said.
So, why are institutions increasing their hedge fund allocation and how are they gauging performance?
Typically, pension funds meet annually to determine the optimal asset allocation with the highest expected return for a given level of volatility going forward.
Steinbrugge points out that a diversified hedge fund portfolio has a low correlation to long-only benchmarks, which can improve portfolio diversification and potentially provide downside protection during a market selloff.
A diversified hedge fund allocation can also enhance the forward-looking return assumptions of the overall portfolio.
According to Steinbrugge, most institutions are currently using a return assumption of between 4% and 7% for a diversified portfolio of hedge funds, which compares favorably with core fixed income, where the expected return is only 2.5% to 3%.