How Asset Owners Are Using Hedge Funds to Replace Fixed Income

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Hedge funds aren’t dead yet, according to TIFF Investment Management’s chief executive officer Kane Brenan.  

In fact, the $7.7 billion outsourced chief investment officer firm has seen an uptick in interest from clients, Brenan told Institutional Investor. “The performance has held up reasonably well through 2020,” Brenan said of hedge funds. “They navigated the downturn and recovered reasonably well from it.”  

This interest comes as some allocators, including the University of Nebraska Foundation, the University of Auckland Foundation in New Zealand, and San José’s retirement plans have either nixed or reduced their hedge fund allocations.  

Despite the headline-grabbing moves by some pensions and foundations, Brenan pointed out that in recent months, there have been more inflows than outflows in hedge funds. “That is notable,” he said. “Just the absence of that negative is interesting.” 

However, he added, investors’ reasons for allocating capital to the asset class have changed — as have the types of funds they’re interested in.  

Brenan believes that one of the primary reasons investors are moving money back into hedge funds is that they’re struggling to find investments that can replace the conservative risk-return profile of fixed income. For decades, investors have relied on fixed income to be low risk and provide stable returns. With interest rates at record lows for a decade, most fixed-income investments provide little income — in most cases, not enough to offset inflation. At the same time, if interest rates rise from their lows, government and corporate bonds will suffer significant declines.

“There is a real move to try to find something that replaces fixed income,” Brenan said. But most investments are riskier than traditional corporate and government bonds. “More equities and more private equity are not the right answer for everyone.” 

Hedge fund strategies can be an appropriate replacement for fixed income in certain cases, as the best managers can provide risk management and can offer some market upside, Brenan noted.  

While in the past, investors may have turned to alternative risk premia as a substitute for traditional hedge fund investments, those days are gone, said Brenan. Alternative risk premia assets — sometimes offered through a liquid alternatives mutual fund — had promised hedge fund-style strategies like momentum or volatility investing, on the cheap. Overall, liquid alts have underperformed over the last decade, according to Morningstar. Risk premia strategies lost 11.3 percent in 2020, according to hedge fund research firm PivotalPath. The funds were up in 2019, but lagged major indices that year. They fell 8.7 percent in 2018. 

“Five years ago, everyone thought that you can get a lot of the same premia that hedge funds give to you through these models,” Brenan said. “They didn’t deliver as much as people hoped.” 

This, coupled with the fact that hedge fund fees have come down in recent years, makes returning to the asset class more attractive. Hedge funds once charged a standard 2 percent management fee and took 20 percent of profits. But that standard is now closer to a 1.5 percent management fee and a 15 percent incentive fee. 

As TIFF puts capital to work in hedge funds, Brenan said the OCIO firm is looking to invest in active managers playing in inefficient markets, including emerging ones.  

“It’s not just let’s go find an equity long-short manager,” he said. “It is finding these niche markets with structural market opportunities.”