Poor Hedge Fund Returns Set to Last, Say Investors

Investors are lowering expected returns and risk for hedge funds, according to Deutsche Bank.

Investors were largely dissatisfied with their hedge fund portfolios in 2014 and expect returns to be lower in the years ahead, according to Deutsche Bank.

Two-thirds of 435 investors representing more than $1.8 trillion in hedge fund assets said their allocation did not meet target expectations last year. Only 27% said they met their target while an even lower 7% outperformed.

“Investors are generally utilizing hedge funds for steady and predictable return streams, rather than for outsized performance.” —Deutsche BankThe respondents’ disappointment is reflected by hedge funds’ overall underperformance. Their portfolios returned 5.26% on average, according to Deutsche Bank’s research, lagging behind the average expected return of 8.11%. The average investor was 285 basis points short of their weighted average target, the report said.

Furthermore, the divergence of hedge fund performance was greater than ever, making access to the most skillful managers critical to success. The average hedge fund returned 3.33% in 2014, Deutsche Bank said, citing HFR, but the top-fifth percentile produced returns higher than 22%.

Investors also cut their expectations for hedge fund performance, with only 14% of respondents targeting returns over 10%, down from 37% last year and 57% in 2010.

Target volatility was also lower for respondents at 5.97%, dropping from 6.74% last year. An overwhelming majority (97%) said they now target single-digit volatility for their hedge funds.

“Investors are generally utilizing hedge funds for steady and predictable return streams, rather than for outsized performance,” the report said.

Investors predicted the hedge fund industry to reach $3.05 trillion by the end of 2015, according to Deutsche Bank. However, research by data firm Preqin has calculated that the industry’s total assets already passed that level in 2014.

Despite lower return expectations, almost half of responding institutional investors said they are set to increase their allocations to alternatives over the next 12 months, while 39% said they plan to grow their hedge fund programs.

Endowments and foundations continued to have the most appetite for alternatives and hedge funds—with a 49% and 25% allocation respectively—but public and corporate pension funds also boosted their absolute return portfolios, the survey found. A typical pension fund had a 20% allocation to alternatives and a 7% exposure to hedge funds.

Investors also preferred larger managers, with 63% allocating to firms with more than $1 billion. In contrast, those allocating to firms with less than $1 billion fell to 36%, from 39% last year.

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By Sage Um