Outflows from hedge funds are accelerating. Hedge funds are now finding themselves on the defensive from poor performance, high fees, unfriendly legal structures, and an onslaught of negative publicity. Investors were already becoming more conscious of fees amid low nominal returns. Now a new dynamic is setting in: fear.

Those who are still invested in hedge funds are right to worry about whether today’s flood of outflows will induce tomorrow’s lowering of the portcullis, with hedge funds invoking gates to prevent investors from running en masse. Runs on banks can happen very suddenly, hence the time-tested maxim: “If you are going to panic, panic first.” But here’s a more benign view of hedge funds’ future.

Runs on banks can happen very suddenly, hence the time-tested maxim: “If you are going to panic, panic first”

Five years from now, there will be no hedge fund allocation.
In its place will be the total return allocation. This will consist of a whit-tled down group – in numbers and fees – of surviving, talented hedge funds that tear down their gates and earn their keep net of fees, blended with managers of liquid alternatives. Just as multi-strategy hedge funds eclipsed their single-strategy counterparts, so too will multi-asset strategies incorporate and push aside single-strategy liquid alts. This new and improved allocation will have low-er overall fees, boost transparency, and deliver better and more dif-ferentiated riskadjusted returns (Sharpe ratios).

The UK has already evolved toward 10%-15% multi-asset (which they call diversified growth)”

Within most portfolios, we’ll see differing blends of total re-turn.
At one end of the spectrum will be total return blends that focus more on seeking a capital appreciation outcome. Here, more growth-oriented multi-asset liquid alts will be teamed with long-biased multi-strategy hedge funds. Together, they will cannibalize equity and private markets to deliver returns based on capital appre-ciation while taming volatility – without the need to tie up capital for up to a decade at very high fees. On the other end of the spectrum will be blends that deliver capital conservation, with multiasset liquid alts focused on absolute return teamed with multi-strategy hedge funds focused on relative value. As interest rates start to rise, inves-tors will increasingly see these blends as a more stable and steady source of capital preservation. Most portfolios will blend strategies focused on capital appreciation and capital conservation depending on the client’s objective.

The total return allocation will grow to help constituencies achieve outcomes that are important to them.
With lower nominal returns and rising volatility, blending and increasing the size of the total return allocation – an outcome-based strategy – will be the or-der of the day for most portfolios. Outcomes include compounding money in real terms over inflation by certain hurdles over defined time frames. For example, an outcome could be exceeding inflation by 3% per year over rolling three years, or by 5% per year over roll-ing five years. This allocation will be more of a talent pool than an asset class, focused on achieving higher Sharpe ratios than those of traditional asset classes.

Today’s 10% allocations to hedge funds will give way to 20% al-locations to total return.
Within US institutional portfolios, hedge funds will shrink from a 10% allocation to 5%, while liquid alt forms of multi-asset will grow to 15% to lower fees while enhancing liquidi-ty and transparency. Of course, this will differ by region. The UK has already evolved toward 10%-15% multi-asset (which they call diver-sified growth). This will keep growing to 30%. Australia is furthest along in eliminating hedge funds, owing to unseemly fees.

The UK has already evolved toward 10%-15% multi-asset (which they call diversified growth)”

Comparable talent found in liquid alts will have the edge.
This is because of their lower fees, higher liquidity, and greater transparen-cy. Liquid alts also tend to be attached to more formidable and but-toned-down marketing and compliance organizations than hedge funds are – an important consideration in the post-Bernie-Madoff world.

Relative return has worked well for asset managers, yet only in sec-ular booming markets. Gone is the 30-year disinflationary tailwind that enabled booming markets with shrinking volatility. The total re-turn allocation will manage to objectives, not benchmarks, gradually weaning away the overall portfolio from relative return investing. As regimes evolve, so too must portfolios.

Gone is the 30-year disinflationary tailwind that enabled booming markets with shrinking volatility”

This article was originally published on 26 September 2016. Please this link to read the original