Institutional investors set to dump poor hedge fund performers

Last year was the second-worst year for hedge fund performance in the 22 years that Hedge Fund Research Inc. has tracked industry returns, and the patience that institutional investors had for subpar hedge fund performance is evaporating fast, industry sources said. Industry insiders predict that this year will be characterized by significant manager rotation within hedge fund portfolios. “The hedge fund investment trend won't reverse, but many institutional investors will be carefully evaluating how individual managers and strategies contributed to their portfolios,” said Anita Nemes, managing director and global head of capital introduction in Deutsche Bank AG's Hedge Fund Capital Group. “This assessment is precipitated by huge performance dispersion in 2011 in some strategies, like long/short equity, but investors will be making their assessment over the longer time frame of the past few years.”

FUNDS TOOK A BEATING

Last year was only the third since the HFRI Fund Weighted Composite Index's inception in 1990 in which the index's return was negative, at -5.02%. The 2011 returns of hedge funds of funds were even worse, with the HFRI Fund of Funds Composite Index producing a dismal -5.51%. By comparison, the S&P 500 returned 2.1% last year; the Russell 3000 Index 1.03%, the Morgan Stanley Capital International All-Country World Index -6.69%, and the Barclays Capital U.S. Aggregate Total Return Index 7.84%. “2011 was a good testing ground for hedge fund managers who professed to be able to manage risk. Those hedge funds that were not able to preserve capital are going to be under scrutiny,” said alternative-investment consultant Stephen L. Nesbitt. “The tide went out last year, and you could see who didn't have any pants on. Managers complained that everything was correlated in 2011 and they couldn't be expected to perform,” said Mr. Nesbitt, chief executive of Cliffwater LLC. “There's always an excuse.” With chief investment officers weary of excuses, Mr. Nesbitt said that he expects “an above-average number of manager searches” this year, similar to the first half of 2009, when investors upgraded their manager rosters after the financial crisis. Mr. Nesbitt said that Cliffwater's own clients likely will be among those making changes, but he declined to disclose any names. The biggest change for institutional hedge fund investors since 2008 has been “so much more emphasis on bottom-up manager selection. And if you were not achieving your performance expectations, how you can effect a change going forward is through manager changes,” Ms. Nemes said. “Fundamentally, institutional investors are not focused on changes to hedge fund portfolio construction as much as they are on assessing which managers will do best in the strategy weightings within their portfolios,” she said. Part of that evaluation has to include assessment of the individual manager's ability to find investment opportunities regardless of market conditions, said Michael Rosen. As principal and chief investment officer of Angeles Investment Advisors LLC, he advises institutional clients on hedge fund investments and manages the firm's $160 million hedge-fund-of-funds strategy. “You have to analyze the purpose of each hedge fund in your portfolio and what your expectation of that manager is,” Mr. Rosen said. “If a merger arbitrage manager is sticking to his investment strategy, and the market isn't favoring merger arbitrage, then that manager may be meeting your expectations.” In a manager-by-manager portfolio evaluation, the hedge funds that he and his team are most focused on are those in which the manager's investment process hasn't worked and the manager seems “unsure about where to find opportunity. The question is not really so much about performance as it is about the lack of agility, the inability to see how they can make money,” Mr. Rosen said. Sources were unable to give specific examples of hedge fund and hedge-fund-of-funds managers that have seen big redemptions or are among those most likely to be excised from institutional investors' portfolios. But “drawdowns of a certain size will definitely put a hedge fund in the running” for replacement, said Donald A. Steinbrugge, managing member of third-party hedge fund marketing firm Agecroft Partners LLC.

ATTENTION GETTER

“Any drawdown of 30% or more just is not acceptable and will not be tolerated,” he said. As investors upgrade, they will be looking for hedge fund and fund-of-funds managers with strong risk controls that allowed them to produce positive returns last year despite extreme market volatility and high correlations between asset classes, Mr. Steinbrugge said. One institutional hedge fund manager — Bridgewater Associates LP — produced 15.3% in its Pure Alpha II fund last year. It had annualized returns of 14.6% for the 20-year period ended Dec. 31. The institutionally focused hedge fund Renaissance Institutional Equities Fund, managed by Renaissance Technologies Corp., also had strong performance — 35% — last year, though net inflows were “negligible,” according to a source who asked not to be identified. Jonathan Gasthalter, a RenTech spokesman, declined to comment. Institutional CIOs might need to move fast if they want to upgrade to last year's best performers, Simon Ruddick, managing director and chief executive of hedge fund consultant Albourne Partners Ltd., wrote in an e-mail. “Capacity is fast disappearing with those better-known funds that performed well in 2011, so opportunities to switch into them may well become limited. After way more talk than action, 2012 might see some shift to smaller funds,” Mr. Ruddick wrote. Christine Williamson is a reporter with sister publication Pensions & Investments.