According to Lonsec Research’s recently released Alternatives Sector Review, alternative funds have significantly underperformed both equity and bond benchmarks over the last five years, with fees and a poor macro environment weighing on returns. But despite this underperformance, alternatives are still seen by investors as a valuable addition to their portfolios, particularly in terms of providing diversification benefit, with client interest ticking upwards over the past two years.
“There are a number of possible explanations for the underperformance of hedge funds as a sector,” said Michael Elsworth, General Manager Alternatives and Specialised Research. “One is that the sector and individual funds are becoming too big. Another is that hedge funds are finding it increasingly difficult to deliver alpha in the current macro environment, which has been exacerbated by ultra-low interest rates and quantitative easing, and which has produced lower dispersion between securities and higher correlation between the major asset classes.”
Recent underperformance was reflected in Lonsec Research’s Alternative fund ratings, which were negatively skewed, with a higher number of ‘Investment Grade’ ratings than ‘Highly Recommended’ ratings. In the 12 months to 31 August 2016, total returns across the broader Alternatives asset class ranged from -33.0% to 8.5%, while the median fund return was modest 2.8%.
“It’s certainly not the recent performance of alternatives that’s driving demand,” said Elsworth. “Essentially, investors are assessing the risk and return trade-offs offered by equities and bonds, and they don’t particularly like the look of either at current levels. Yields have been driven to record lows, while share markets have been priced ever higher, and investors are keen to find something that is not correlated with these major asset classes.”
Fund flows are steady but some funds are getting the lion’s share
Lonsec Research has seen client interest in alternative strategies pick up over the last two years, although this renewed interest has not yet translated into a material level of overall fund inflows. Based on current levels of interest, the sector may experience an increase in fund inflow, although it may not be spread equally across the sector.
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“We have seen an overall increase in fund flow within Lonsec’s Australian advisor channels,” said Elsworth. “However, it is worth noting that only a handful of funds have seen significant inflows. As has been the case since the GFC, the big winners in terms of fund flows and market share still appear to be well established hedge fund managers with strong reputations and established brand names. Of the funds covered by Lonsec Research, recent inflows have predominantly headed in the direction of managed futures strategies, which have demonstrated strong long-term track records.”
According to Lonsec Research, the shift in appetite for alternative funds predominantly reflects concerns around the macro environment, and in particular the fear that correlations between traditional asset class returns may converge. This have led financial advisors and investors to consider other strategies with the ability to drive returns, particularly those which have historically displayed – or have the potential to display – low correlation of returns to bonds and equities.
