Pension funds will increase their allocations to hedge funds in 2020, due to lower interest rates and credit spreads, according to Don Steinbrugge, CEO of hedge fund consulting firm Agecroft Partners and a renowned expert in the industry.
Part of Agecroft’s trend predictions for the new year, the pension projection rests on the entirely reasonable notion that fund chiefs will want to lower their exposure to fixed income.
Public funds, which various research findings say invest about 5% of their assets or less into hedge funds, have an actuarial rate of return assumption of 7.5%. With 10-year Treasury notes yielding less than 2% and all but the riskiest junk bonds exceeding 7.5%, the large amount devoted to bonds (around 40%, by State Street Global Advisors’ count) looks increasingly ill-advised.
“With the yield on the aggregate bond index in the mid- 2% range, the bar is low for hedge funds to add value on a risk adjusted return basis,” Steinbrugge wrote in the report. He suggested that pension plans might choose among a range of different hedge strategies to place their rerouted money, including distressed debit, specialty financing, structured credit, and relative value fixed income.
In performance terms, the hedge fund industry has faced rough going in recent years. But at least 2019 was decent, albeit not overwhelming. Hedge Fund Research’s Asset Weighted Composite index rose 7.7% in the 12 months ended December 31, versus a 0.7% dip in 2018. Note that investing in an S&P 500 index fund, which costs a lot less than a hedge fund, would have gained nearly 30% last year. To be sure, hedge fund fans point out that the purpose of this asset class is not to beat the market, but to provide diversification and downside protection during bearish times.
Despite moves by giants like California Public Employees’ Retirement System and New Jersey’s State Investment Council to trim their hedge fund exposure, there has been a growing movement to adopt this asset class, especially among institutional investors. Steinbrugge predicted that this movement will continue. “Hedge fund industry assets under management will grow for the 11th time in 12 years in 2020,” he stated.
Other trends Agecroft’s report highlighted include a slight decline in revenue owing to lower fees. The traditional arrangement—of a 2% yearly management fee and 20% of any profit—has come under fire. Meanwhile, he noted, the number of hedge funds will continue to drop, which means the top 5% of the industry, in investors’ estimations, will benefit the most from this shrinkage. Steinbrugge has long complained that marginal players are dragging down the overall industry performance.